## SA equities: Basic fundamental factor portfolios

I wanted to switch gears a bit from momentum and look at some fundamental factor screening portfolios. Here I am only interested in using historical fundamental data. Also note that I have lagged all fundamental data by 3 months to reduce the impact of backfilling.

I have tried to use fairly basic factors. A few “value” based factors:

- Dividend Yield
- EV/EBITDA
- Price-to-cashflow
- Price-to-book
- Price-to-earnings

and what I guess you would call “quality” based factors:

- Return on assets
- Return on equity
- Return on invested capital

There are a lot more factors but I just wanted to get started on the simple ones.

(As an aside here is a nice post on the impact of using forward or trailing PE ratios: https://blogs.cfainstitute.org/investor/2016/07/12/dumb-alpha-trailing-or-forward-earnings/)

In general I am keeping the portfolio construction process very similar to the momentum portfolio construction process from previous posts.

- At the end of each month I rank the top 80 stocks (as at each month) according to a specific fundamental factor.
- Place each stock in one of five portfolios, from most favourable to least. For example from highest DY to lowest or lowest PE to highest.
- Equal weight each stock using closing prices of the following trading day (i.e. I am assuming that the portfolio is readjusted at the end of the next day).
- Allow the weights to float until the next formation/month (this replicates an actual portfolio – each stock is equal weighted at the beginning of the month but price changes will change the weights during the month).
- Returns are net of dividends and capital adjustments and exclude transaction costs.

For every factor I just going to put a chart of the cumulative performance and then a statistics table. I provide a brief explanation of the table below, otherwise I also provide some of my thoughts on each factor. In the next post I will look at combining the value factors with the quality factors and see if we can improve the portfolios.

Just in general though, a few things I am looking for:

- Good separation of portfolios in a sensible order should illustrate selection power of the factor (i.e. lowest PE should have the best return and declining from there as we move down the quintiles)
- A Sharpe of over 1 and a Sortino of close to 1.5
- A good size alpha per unit maximum drawdown. For me this is a measure of “easy” it is to stick with the strategy in a down turn
- Obviously a large probability of a stock leaving the portfolio with a positive return
- A fair time in the portfolio – we want to limit churn as much as possible.

The chart gives you the cumulative performance (log-scale) for each quintile portfolio. I have also provided the performance of the market. However, note this isn’t a JSE index. It’s a market cap portfolio which is rebalanced every month and will differ slightly from official indices due to, amongst other reasons, free float weights and the quarterly rebalance (as opposed to monthly) of JSE indices.

In the table I have shown the annualised return, volatility and downside deviation. Also the corresponding Sortino and Sharpe ratios. I have also looked at maximum drawdowns and a measure I call alpha per unit maximum drawdown (Alpha_maxDD). This measures the alpha (over the market cap index) relative to the strategy’s maximum drawdown. The higher the alpha per until maximum drawdown the better. Prob_Up is the probability that a stock leaving the portfolio does so with a positive return since entering and Avg_Time is the average time a stock will stay in a portfolio (measured in months).

**Dividend Yield (DY)**

DY doesn’t fair too badly although the spread in returns is not that great and quintile 2 has just recently surpassed quintile 1. Quintile 4 also sits in a weird spot between quintile 2 and the market.

**EV/EBITDA**

EV/EBITDA looks promising. A nice sensible spread in returns: quintile 1 and 2 with the highest returns, quintile 4 and 5 with the lowest. Although. Quintile 5 has caught up a lot of ground recently while quintiles 1 and 2 have pulled back significantly. Probably a sign of the period we have just emerged from. Important to note financial stocks will not have an EV/EBITDA and so will naturally be excluded. (Perhaps we can use PCF in the case of financials and EV/EBITDA for everything else)

**Price-to-book (PB)**

A favourite in the market, PB, has probably the worst experience. Both quintile 4 and 5 outperform the other portfolios* (i.e. the highest and next highest PB stocks). Every other portfolio has returns similar to the market. Not a great separator then.

*Perhaps there is something wrong in my back test but I have triple checked this!

**Price-to-cashflow (PCF)**

PCF is a bit of a weird one. Quintile 2 and 3 are clear winners while quintile 1 is sort of middle of the pack. Just as in the PE case (see below), avoiding the highest PCF stocks seems to be a good way to go.

**Price-to-Earnings (PE)**

The fan favourite, the PE ratio. It had a great run until about 2013 where things went horribly wrong (probably due to resource heavy portfolios). Quintile 4 actually does really well – almost as well as quintile 1 – which makes me question its ability to separate stocks accurately but this is only recently. Pre-2009 wasn’t much difference between the portfolios. It does seem to indicate that you should avoid the highest PE stocks at all costs.

**Return on Assets (ROA)**

ROA actually comes across as the best factor. A decent and stable spread in the portfolio returns. Quintile 1 returns of close to 20% per annum, alpha per unit max drawdown of over 12% and an average time spent in the portfolio of 11 months. My pick of this bunch really.

**Return on Equity (ROE)**

ROE is another favourite which actually doesn’t look too great. Quintile 2 is the second worst performing portfolio while the second best portfolio happens to be quintile 4. Not really the order we are looking for.

**Return on Invested Capital (ROIC)**

ROIC is actually fairly decent. Not as good as ROA but better than ROE. There is some order in the returns but quintile 5 just does too well for me to consider it a good stock separator.

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*Although every effort is made to ensure accuracy in the data and analysis presented on this site, this cannot be guaranteed. Nothing on this site constitutes investment advice, nor should it be taken as such. And obviously, past results do not guarantee future performance.*