Building a Strategy - Quality before Quantity

Find out how to build a strategy that focuses on quality UK stocks using the Piotroski F Score, ROIC and Price to FCF / Earnings.

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Written by Liam Flavelle on 30 May 2018

  • I've created a strategy that buys invests in quality companies.
  • You can identify companies poised to increase in value by buying companies in the UK with high Piotroski F Scores and Returns On Invested Capital.
  • Purchasing stocks with the lowest Price to Free Cash Flow and Earnings ratios provides an effective timing element.
  • The strategy also works well around the world.

UK Quality

Click on the image to view the strategy

Introduction

Everybody wants to own quality stocks in their portfolio, as in theory they should show greater price appreciation than their more ordinary peers and provide more of a safety net during times of market-induced stress.

The problem with buying quality stocks is two fold - how can you determine if a stock falls into the quality bracket and how do you make sure that you don't overpay for it?

To answer these two questions I've been using the InvestorsEdge.net platform to develop a new strategy that shows great promise.

As usual, each version of our model can be accessed through the History button on the results page so you can track how I've built and refined the strategy, and I have also used the built in sample dates to discourage data mining. All of the versions were developed using the In Sample date range (1st January 2015 - 28th May 2018) and then backtested against other date ranges once the final version was completed.

Our Starting Point

When I am trying to identify quality stocks my first starting point is generally the Piotroski F Score. This simple yet powerful factor grades a company from 0 to 9 (higher numbers are better) with companies that have shown recent improvements in returns, cash flows and debt scoring higher than those with more ordinary returns.

Our starting strategy will simply be to each week buy the top 10 companies in the UK with the highest Piotroski F Scores. Here's how the initial model works out:

UK Quality

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You can see from the chart that our returns would have been pretty good - approximately 20% over the last 3.5 years with Sharpe and Sortino ratios (measures of risk-adjusted returns) of 1.16 and 1.65.

So have we identified our perfect strategy? No - looking at the blue equity curve that represents the value of our portfolio you can see that it is a jagged line. So, in search of a better looking chart let's add some more factors.

Improvement 1 - Price to Earnings Ratio

My initial strategy just blindly buys the companies with the best Piotroski Scores. After testing and discarding changes to EPS as a ranking factor I started looking for price ratios that would add an element of market timing to the model. My thinking on this is that quality companies that are cheaper will give me greater capital gains than those that are more expensive.

I struck gold on the first factor:

UK Quality

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The new version of the strategy backtests our UK universe of stocks with two ranking factors - Piotroski and Price to Earnings. The order of stocks is still heavily weighted (75%) towards the Piotroski score, with the PE ratio being used to bias the selection of companies towards the cheapest stocks.

Improvement 2 - Price to Free Cash Flow

While this is a great improvement, you can see that our equity curve is still jagged and that the market correction we've been enjoying this year caused an unwelcome (15%) drop in the value of our portfolio. In an attempt to smooth our returns I tried all of the other common price ratios and only one, Price to Free Cash Flow, improved our returns in the same way. Better still, when combined they produce these backtested returns:

UK Quality

Click on the image to view the strategy

Our model now ranks our UK universe of stocks by Piotroski F Score (75% weighting) and Price to Earnings and Price to Free Cash Flow ratios (both with a 12.5% weighting).

The model also incorporates a maximum weighting in any one sector of 25%, as I noticed that the strategy had a tendency to focus on and overweight sectors that were lagging the rest of the market.

Improvement 3 - Return On Invested Capital

In one of my previous blogs (Do Capital Returns Matter?) I found that companies in the UK with higher Returns On Invested Capital (ROIC) tended to outperform their peers, so I decided to add in ROIC to the mix:

UK Quality

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While this new factor reduces our overall returns down by 2% annually, it pushes our backtested Sharpe ratio above 2 for the first time. For me personally I consider this a better result as I am sacrificing a little performance for a less volatile ride.

Why This Strategy Works

In a nutshell, this strategy works by combining two elements, quality with attractive prices.

The Piotroski F Score seems like a simple number, but it hides a number of more complex moving parts. To score 9 points, a company must have:

  1. Positive Net Income
  2. Positive Return On Assets in the current year
  3. Positive Operating Cash Flow in the current year
  4. Cash Flow from Operations greater than Net Income
  5. Lower ratio of Long Term Debt compared to the previous year
  6. Higher Current Ratio than the previous year
  7. No new Shares issued in the last year
  8. Higher Gross Margin compared to the previous year
  9. Higher Asset Turnover ratio compared to the previous year

Our decision to give the Piotroski factor the highest weight in our ranking elements biases our selection of companies to those that have shown the highest profitability, liquidity and efficiency with the lowest debt and share dilution.

The Return On Invested Capital (ROIC) factor provides a minor influence to our selection by ensuring that out of the companies with good Piotroski Scores the system selects those stocks that utilize their capital efficiently. ROIC is calculated by dividing a company's Net Operating Profit After Tax (NOPAT) by its average Invested Capital over the last year.

Finally, our strategy uses two price ratios, Price To Earnings (PE) and Free Cash Flow, to adjust the sort order and give prominence to those that are relatively undervalued. I was quite surprised that the PE ratio worked so well as I typically find it a poor indicator of future performance, possibly because everybody uses it to gauge cheapness. Combining the two factors reduces false signals in our strategy and improves the volatility of our returns.

Final strategy

UK Quality

Original Version - Click on image to view

UK Quality

Final Version - Click on image to view

When backtested from 2010 to May 2018 our final strategy shows a dramatic improvement from our starting point - annual average returns are up 5%, the maximum drawdown has dropped 7% and our Sharpe and Sortino ratios have increased.

UK Quality

UK Quality

UK Quality

When examining the results in more detail, we can see that our strategy predominantly invests in smallcap companies (those with market valuations between £180m - £1.4bn) whilst the average holding period was between a week and a month. From an annul performance perspective, the strategy suffered in two years, almost certainly due to macro-economic events.

During 2011 the Euro crisis was occupying our minds, whilst 2014 saw oil prices plunge, fears of the Chinese economy imploding and yet another issue with the Eurozone. During the years when investors weren't worried about the sky falling the strategy performed exceptionally well!

Does Our Strategy Work In Other Countries?

One measure of a strategy's robustness is how it performs in other regions:

UK Quality

Whilst not matching the level of risk-adjusted returns our UK strategy gives us, all regions provide decent annual returns of between 18% and 27%, with US stocks actually showing higher total returns over the backtested period than our UK version of our strategy.

Conclusion

The model that I have created shows great promise - it focuses on buying quality companies that are relatively cheap and works across a range of timescales and regions while minimizing volatility. I will be testing the strategy over the next few months to see how it performs in the real world and will report back periodically.

If you would like to play with this strategy to see how you can improve on what I've created you can click here (if you haven't registered you can sign up for a free trial below):

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