WHAT ARE WE LOOKING FOR? Companies that have the least risk during an economic crisis. Yin Luo, quantitative strategist at Macquarie Securities, recommends a portfolio strategy each month for this column, and this month he suggests looking at stocks with a low risk of credit default. LAST MONTH For October, Mr. Luo recommended a momentum strategy in a volatile and deteriorating market, using a price-to-52-week high indicator. His portfolio lost 10.4 per cent in the month, while the S&P/TSX composite index was down by 17 per cent. A strategy of going long on his portfolio and shorting the index would have produced a return of 6.6 per cent in the month. Since Mr. Luo started to contribute to the column, his strategy has outperformed the benchmark in 13 out of 17 months. THEME FOR NOVEMBER Mr. Luo believes his strategy for November is perfect for the credit crisis that won't go away. "Even well-capitalized companies may face difficulties in refinancing their liabilities," he said. "Investors are increasingly cautious about companies with high default risk." Traditionally, investors rely on either financial ratios or debt rating agencies in assessing credit risk, Mr. Luo said. Investors calculate current ratios, debt/equity ratios, and profitability ratios, but these ratios can be too backward looking. "At the same time, rating agencies also failed to catch many of the recent credit catastrophes." Mr. Luo recommends investors turn to Merton's default model, which analyzes companies' solvency prospects by using financial ratios and equity volatilities. "Our back-testing suggests that Merton's model has helped quantify default risk much more successfully in the recent cycle, in both Canadian and U.S. equity markets."
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