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Did your portfolio fail its stress test this week?

One of the most volatile weeks in ages for stocks has reminded us to pay more attention to risk. Diversifying with stocks and bonds is the best risk-reduction strategy, but some investors are looking for more. They may find some answers in the Pay Attention To Risk strategy, an attempt to find a liveable balance of risk and reward.

The PATR strategy is the result of a conversation I had as the stock markets tanked this week with Rob Davies, account manager at Morningstar CPMS, a North American equity ranking and screening service used by institutional money managers and investment advisers. I asked Mr. Davies if he had anything for investors who pick their own stocks and want something that holds up well in market corrections. What he came up with was a portfolio of 20 TSX-listed stocks that have beaten the overall stock market in the past with less risk.

You'll find the stocks in the portfolio listed in the chart accompanying this column. Clearly, it's not the perfect portfolio for every worried investor. While most stocks in the portfolio are up for the year to date, several have fallen sharply. Also, the portfolio includes Valeant Pharmaceuticals, which was up 82 per cent for the year through mid-week and 487 per cent in total over the past three years. Valeant was down 7.2 per cent for the month, but it hardly seems a buy-low opportunity.

Still, the entire list of stocks scores well in a variety of measures that indicate a degree of resilience in a down market. "We've found from various tests over the years that these variables are the key components to look at to minimize risk," Mr. Davies said.

In order of importance, the screening process used for PATR covers the following criteria:

Five-year beta: Beta is a mix of stock market volatility where a benchmark stock index is assigned a beta of one; strategy is seeking less volatile stocks with betas below that level.

Low earnings estimate spreads: Analysts are generally in agreement about the company's current year earnings; management likely has a good reputation for providing accurate guidance.

Return on equity: Looking for high 10-year average numbers in this measure of profitability.

Price-to-earnings ratio: Looking for a low P/E in relation to the historical median.

Price-to-book ratio: Again, looking for a low number in relation to the historical median; this ratio compares a company's market price to its book value, or assets minus liabilities.

Low historical earnings variability: Consistent earnings, in other words.

The PATR strategy delivered a total return (share price change plus dividends) of 18.9 per cent over the 12 months to July 31, a period in which the S&P/TSX composite index lost 2.9 per cent. Back testing shows that since the start date of January, 1996, PATR has achieved a total return of 15.2 per cent and the index has made 8.1 per cent. Such pronounced outperformance should make you think extra hard about the usual boilerplate saying past returns are no guarantee of future results. High-flying investments do have a tendency to fall back to the pack.

Another proviso is that those long-term results were based on monthly portfolio rebalancing. This is virtually impossible for individual investors to do on their own, but here's some consolation: Over those two decades, the average annual portfolio turnover rate was a very low 12 per cent. "What this indicates is that a lot of the stocks in Canada that have a low-risk profile tend to be fairly stable over time," Mr. Davies said. "We don't get a whole new list every year."

PATR's strong long-term results appear to be based more on limiting the stock market's down side than on capturing all the juice in upside gains. The strategy has beaten the S&P/TSX composite index in 93.3 per cent of months in which the index was down. In the 2008 stock market crash, the portfolio's drop of 24.3 per cent compared to 33 per cent for the index.

"This portfolio hasn't performed as well as some of the other strategies we have when the market turns up, but I was quite pleased to see how well it did in down markets," Mr. Davies said.

A notable feature of the list of PATR stocks is the comparatively modest presence of the big blue chip names that dominate the S&P/TSX composite index. Only one big bank, National Bank of Canada, made the list, and there are no big energy or telecom stocks. Instead, there's a heavy weighting in medium- and small-size companies like Jean Coutu Group, Richelieu Hardware and Leon's Furniture.

Mr. Davies said he simply applied his screen to the 700 or so stocks in the Canadian market. "Our model is totally unbiased. It's bottom-up stock selection and often you'll find this produces names that you don't hear about every day." Bottom-up stock picking means analysis of individual shares; top-down investing is about looking at big-picture issues like the economy.

Recognizing that some investors prefer more of an emphasis on large stocks, Mr. Davies re-ran his screen to eliminate stocks with a small market float (float means shares in public hands) and lower trading volumes. This resulted in the addition of BCE Inc., TransCanada Corp., Toronto-Dominion Bank and Bank of Nova Scotia and the removal of Winpak Ltd., Leon's Furniture Ltd., Atco Ltd. and Valener Inc. Twenty-year returns from the portfolio with a large-stock tilt fell slightly to an average annual 14.8 per cent.

Dividends are another area where PATR has done well. The original version of the strategy produced a dividend yield of 3.9 per cent at mid-week, compared to 3.3 per cent for the index.

Want to get to know these PATR stocks better? Add them to a Globeinvestor.com watchlist (globeandmail.com/globe-investor/my-watchlist) and you'll be able to look at things like dividend growth and payout ratio (select the Dividend view), return on equity (choose the Earnings view) and P/E and price-to-book ratios (go with the Ratios view). In the Build Your Own view, you can add things like analyst consensus recommendations and an indication of where a stock is trading in relation to its 50- or 200-day moving average.

If you're starting to pay attention to risk again as an investor, focus first on having the right mix of stocks and bonds and keeping a long-term perspective that assesses returns in five-year increments at least. The Pay Attention To Risk strategy is for people who want to take risk reduction a step further, even while recognizing that you're never free from risk when you're invested in stocks.

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