Dow Theory Forecasts’ stock-rating system, Quadrix®, considers more than 100 variables in six categories — Momentum, Quality, Value, Financial Strength, Earnings Estimates, and Performance. Used together, these scores can help you find winners and avoid losers.

 

No numbers-based ranking system can substitute entirely for company analysis. Stocks cannot be reduced to a series of equations. Often what really matters about a company’s stock is not on the balance sheet or income statement. For example, Quadrix can tell you which drug companies have done best in growing earnings and sales, but it cannot tell you the companies with the best new drugs in the pipeline.

 

Still, a numerical ranking system like Quadrix can be a great first screen for building portfolios. Because the system uses only quantifiable factors, it allows you to narrow your focus on companies achieving superior results. Similarly, because Quadrix is not influenced by the fear, hope, and greed that can cloud the judgment of all investors, the system is an excellent tool for tracking current portfolio holdings.

Quadrix Overview

Quadrix uses more than 100 variables to score stocks in six categories — Momentum, Quality, Value, Financial Strength, Earnings Estimates, and Performance. Within each category, some variables are weighted more heavily based on past effectiveness. To compute an Overall Score, Quadrix uses a weighted average of the six category scores. Based on past effectiveness or expectations regarding market conditions, weightings for the individual variables or the six categories may be changed.

 

For the most part, the Forecasts uses Overall Quadrix scores to find likely 12-month winners. Subscribers with shorter or longer time horizons may want to tailor the system to their needs, so it helps to know the significance of each category.

 

Momentum. To compute Momentum scores, the Forecasts ranks the universe of roughly 5,000 stocks on variables related to near-term growth in earnings, cash flow, and sales. For example, a company that scores in the top 1% for 12-month sales growth receives a 100 for that variable. For a company that scores better than only 5% of the companies for 12-month sales growth, the score for that variable would be 5.

 

For each of the Momentum variables, each stock is compared to the universe of all stocks. To calculate the Momentum score, the sum of a stock’s scores for each variable is compared to the universe of stocks. For example, if a stock receives a Momentum score of 75, that means the average of its Momentum scores is higher than 75% of the universe.

 

Many investors rely solely on Momentum factors when picking stocks. But the Forecasts prefers a more balanced approach, partly because companies with high Momentum scores often have overvalued stocks. Also, because our Momentum variables look back no further than 12 months, Momentum scores can unduly reward companies experiencing a temporary acceleration in business.

 

Still, partly because it can help eliminate companies suffering from deteriorating fundamentals, Momentum receives a healthy weighting in the Quadrix system. In fact, you should be wary of stocks with high Overall Quadrix scores that do not score well for Momentum. Such scores sometimes reflect a temporary slowdown, but they can also point to a stock headed for trouble.

 

By definition, Momentum factors are short term in nature. So, if you buy a low-quality or overvalued stock simply because of its Momentum score, the risk posed by an earnings slowdown is substantial. The shorter your time horizon, the more important is Momentum.

 

Quality. The Forecasts’ Quality score is an excellent gauge of a company’s track record. Most Quality variables are growth rates for sales, earnings, cash flow, common equity, and dividends. Other variables include return on equity, return on assets, and return on investment.

 

Growth rates for the past one, three, and five years are used. So, companies with outstanding 10- or 20-year track records are given no credit beyond the last five years. Companies lacking five-year track records are evaluated based on the average ranks for the Quality variables for which they do have numbers, the methodology Quadrix uses for all missing variables.

 

Companies with the best growth records score highest for Quality. While a good history is no guarantee of future success, companies with stellar growth records tend to be well-managed businesses with attractive market positions. Because Quadrix measures growth in five areas — sales, earnings, shareholders equity, cash flow, and dividends — it penalizes companies growing earnings through cost-cutting or restructuring charges.

 

One shortcoming of Quadrix is the reward it gives companies that have grown through acquisitions. Many of Wall Street’s best growth companies have benefited from acquisitions, including Automated Data Processing, Citigroup, and General Electric. But in general, a company growing internally is more valuable than a company growing only through acquisitions. For that reason, the Forecasts takes a closer look at any high Quadrix scorer with a penchant for acquisitions.

 

Value. Quadrix’s Value variables include such ratios as price/earnings (P/E), price/sales, price/cash flow, price/book value, and P/E relative to expected growth (PEG). In addition, the ratios are compared to the average level of the ratios over the past three and five years.

 

There is no shortage of value plays in the broader market, and we expect the best performers over the next year will be reasonably valued stocks supported by earnings and sales momentum. With some exceptions, the Forecasts sees little reason to bet on deep-discount value stocks lacking solid track records or decent market positions.

 

Financial Strength. Financial Strength scores reflect interest coverage, debt positions, and profit margins.

 

Financial Strength scores can help weed out companies with weak financial positions. Companies with solid balance sheets score best for Financial Strength. By itself, a company’s Financial Strength score is not a great predictor of stock performance. However, a low Financial Strength score is a yellow flag worth investigating.

 

For industry groups that typically use a lot of debt — including banking, financial services, insurance, and utilities — Quadrix Financial Strength scores can be unduly low. For stocks in such sectors, Financial Strength scores are most meaningful relative to industry peers.

 

Earnings Estimates. By tracking the trend in consensus earnings estimates, you can check whether company fundamentals are supporting a stock’s price action. Also, estimate revisions have been a good screen for avoiding companies likely to post negative profit surprises. The Quadrix Earnings Estimate score is based on variables that measure the change in consensus earnings estimates for coming quarters, this fiscal year, and next fiscal year. Earnings Estimates scores can be quite volatile, so the category does not receive a big weighting in the Overall Quadrix score. However, for stocks with low Earnings Estimates scores, you should determine whether the negative revision trends are already reflected in the stock price.

 

Performance. The Quadrix Performance score reflects a stock’s total returns relative to other stocks. Total returns (dividends plus stock-price change) are computed for periods ranging from one month to 12 months. By evaluating a stock’s relative strength over different periods, the Quadrix Performance score can help identify stocks showing consistently superior performance. In general, the shorter your time horizon, the more you should emphasize Performance scores. If Performance scores are weak even though company fundamentals appear strong, you should evaluate whether the company faces near-term problems.

 

Volume Metrics. Quadrix Volume Metrics scores are based on a stock’s recent trading volume relative to its historical trading volume. When trading volume jumps, a stock’s score for Volume Metrics will improve. Because all stocks are evaluated on a relative basis, a market-wide increase in trading volume will not impact the score for Volume Metrics. Historically, trading volume has been a good tool for finding stocks likely to post big moves. However, those big moves can be to the upside or the downside. So, while the Volume Metrics score can be an effective tool for finding stocks that deserve a closer look, the score is not included in the Overall Quadrix score. The Forecasts is doing more work on defining the relationship between trading volume and future stock-price action, so Volume Metrics may be used in the Overall score in the future.

Conclusion

Quadrix is an excellent tool for uncovering buy and sell candidates. Subscribers should not use Quadrix exclusively, since there is much that cannot be captured by a numerical system. Also, Quadrix can also be a useful tool for tracking industry groups. For example, if most of the stocks in a group score well for Momentum, it provides some confirmation that the companies are benefiting from industry-wide trends. In general, industry-wide trends are more likely to persist. Historically, investors have done well buying leading stocks from groups showing good relative strength. Quadrix can help illustrate whether leading groups are gaining because of strong fundamentals.

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