Friday, January 12, 2018
U.S. stocks have maintained their impressive early-year momentum
Heading into the new year, should I tilt my portfolio toward growth stocks or value stocks?
Dow Theory Forecasts' stock-rating system, Quadrix®, uses more than 90 variables in six categories — Momentum, Quality, Value, Financial Strength, Earnings Estimates, and Performance — to calculate Overall scores. Overall scores are designed to measure the appeal of stocks of all stripes using a single yardstick, helping you find winners and avoid losers.
We believe no numbers-based ranking system can substitute entirely for company analysis. Stocks cannot be reduced to a series of equations. Often what may really matter 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, we believe a numerical ranking system like Quadrix can be a great first screen for building portfolios. Because the system uses only quantifiable factors, it is designed to narrow the 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 designed to provide unbiased feedback on current portfolio holdings. Quadrix has done a good job of separating winners and losers since we began publishing Quadrix scores in 2000.
Quadrix uses more than 90 variables to score stocks in six categories - Momentum, Quality, Value, Financial Strength, Earnings Estimates, and Performance. Quadrix also considers trading-volume trends and other data to calculate a score for Volume Metrics, a seventh category that does not figure in the calculation of Overall scores.
Within each category, some variables are weighted more heavily based on past effectiveness. To compute an Overall Score, Quadrix uses a weighted average of six category scores, with Value, Quality, and Momentum receiving the biggest weightings. Based on past effectiveness or expectations regarding market conditions, weightings for the individual variables or the 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 over 4,600 stocks on more than 10 variables related to recent 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 weighted average of its Momentum scores is higher than 75% of the universe.
Some investors rely solely on Momentum factors when picking stocks. The Forecasts prefers a 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 we believe it can help eliminate companies suffering from deteriorating fundamentals, Momentum receives a healthy weighting in the Quadrix system. In fact, we are 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 a low-quality or overvalued stock is bought simply because of its Momentum score, the risk posed by an earnings slowdown is substantial. The shorter the time horizon, the more important is Momentum.
Quality. The Forecasts' Quality score is an excellent gauge of a company’s track record. Of the more than 20 Quality variables, most are growth rates for sales, earnings, cash flow, common equity, and dividends. The other variables include expected profit growth and earnings consistency, along with returns on equity, investment, and assets.
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. 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 more than 20 Value variables include such ratios as price/earnings (P/E), price/sales, price/cash flow, price/book value, price/dividend, 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 history suggests such stocks tend to outperform. In real-time use since 2000 and in back-tests to 1992, Value scores have done the best job of picking winners among the category scores. Still, because of our balanced approach, the Forecasts typically prefers attractively valued growers over deep-discount value stocks with poor track records or weak market positions.
Financial Strength. Quadrix uses more than 10 variables in computing Financial Strength. The scores reflect interest coverage, debt positions, and profit margins. Financial-Strength scores are designed to help weed out companies with weak financial positions. Companies with solid finances score best for Financial Strength. By itself, a company’s Financial-Strength score may not be 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 appear to be 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 Estimates score is based on more than 10 variables that measure the change in consensus earnings estimates for coming quarters, this fiscal year, and next fiscal year. Also considered are variables that consider the number of analysts boosting estimates relative to the number cutting estimates. 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, it should be determined 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. Historically, outperformance in the past two, three, six, or 12 months has been a bullish signal, whereas outperformance over the past three and five years has been a bearish indicator. Total returns (dividends plus stock-price change) are computed for periods ranging from two months to 12 months, rewarding stocks for strong returns. Quadrix also considers three- and five-year returns, rewarding stocks with poor long-term returns.
Most of the weighting for Performance category is attributed to the shorter-term measures, so stocks with strong recent returns earn the highest scores. Performance scores should be watched closely, but they do not receive a huge weighting in Quadrix. In general, the shorter the time horizon, the more Performance scores should be emphasized. 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, which have never been used in the calculation of Overall scores, consider a stock’s recent trading volume relative to its historical trading volume. Also considered are short interest and brokerage ratings.
We believe Quadrix is an excellent tool for uncovering buy candidates. Dow Theory Forecasts does not use Quadrix exclusively, since there is much that cannot be captured by a numerical system. Still, Quadrix is designed to help ensure that we are fishing in the right waters. Dow Theory Forecasts rarely initiates coverage on a stock with a Quadrix Overall score below 80.
Quadrix also is designed to be a useful tool for tracking industry groups. 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. Quadrix is designed to help illustrate whether leading groups are gaining because of strong fundamentals.
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Friday, January 12, 2018
U.S. stocks have maintained their impressive early-year momentum
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