Setting A Brisk Pace

5/7/2012


Plenty of academic research has shown that stocks going up tend to continue going up. However, trying to capture those gains could frustrate even the most patient investor.

According to a study by asset manager GMO that divided a large-cap stock universe into fourths (quartiles) based on returns, investment strategies involving price momentum have worked for decades. From 1927 through 2009, the quartile with the highest trailing returns in periods of six to 15 months outperformed over the following year, with 12-month leaders delivering the best year-ahead returns.

The Forecasts taps into this trend with our Quadrix Performance score. The top one-fifth (quintile) of the S&P 500 Index as measured by Performance score has averaged 12-month returns of 13.8% in rolling periods since 1990, versus 12.7% for the average stock in the index. Stocks in the top quintile based on returns over periods of up to 12 months also tend to outperform.

While strategies based on share-price momentum work over long periods, they tend to be quite volatile. For example, the top one-fifth of Performance scorers in the S&P 500 underperformed the average stock in the index by an average of more than 9% during the 24 rolling 12-month periods starting in January 2008 — this after averaging 3.6% outperformance for the 12 periods beginning in January 2007.

For shorter periods, the ups and downs can be dizzying. If you bought the top quintile of Performance scorers between October 2008 and March 2009 and held for a year, you lagged the average S&P 500 stock by more than 20%. Of course, if you followed the same strategy between June and September 1999, you outperformed by more than 20%.

What does this mean? While a stock's near-term performance has predictive power regarding year-ahead returns, investors should not depend too heavily on price momentum to select stocks. Since 1990, top Overall scorers in the S&P 500 have averaged 12-month returns of 15.4%, outgaining top Performance scorers. However, stocks in the top quintile for Performance that also qualify for the top quintile in Overall — weeding out companies with weak fundamentals — averaged 18.5% returns.

Performance-oriented strategies aren't for everyone. When you focus on
recent price momentum, you tend to end up with a certain type of stock. Within the S&P 500 Index, stocks scoring above 80 in Performance average Momentum scores of 72 (versus 52 for the entire index) and Earnings Estimates scores of 81 (versus 54). This is not surprising, as stocks tend to rise while their sales, profits, and profit estimates are rising. But Performance leaders average Value scores of 39 (versus 57 for the index), suggesting many are overpriced.

PERFORMANCE LEADERS
Below we present 10 A-rated stocks with Performance scores above 80 and short-term returns above those of the average S&P 500 Index stock. We eliminated stocks with poor fundamentals or unduly high valuations by limiting our screen to Overall scores of 80 or above and Value scores of at least 40. Stocks recommended for purchase are presented in bold.
---- Total Returns ----
---- Quadrix Scores ----
Company (Price; Ticker)
3
Mos.
(%)
6
Mos.
(%)
12
Mos.
(%)
Value
Perfor-
mance
Overall
Industry
Advance Auto
($91; AAP)
18
40
39
51
90
95
Retail
Alliance Data
($129; ADS)
16
29
34
51
83
81
IT Services
American Express
($61; AXP)
22
25
25
52
85
88
Finance
Apple ($582; AAPL)
28
47
68
74
92
100
Computers
Comcast ($31; CMCSA)
19
34
23
65
84
95
Mgd. Care
Macy's ($41; M)
24
39
74
69
91
89
Retail
U.S. Bancorp
($32; USB)
15
33
28
67
87
93
Banks
UnitedHealth
($57; UNH)
11
24
16
76
81
95
Mgd. Care
Wells Fargo
($34; WFC)
18
39
19
84
85
93
Banks
Wyndham ($51; WYN)
29
57
49
40
93
90
Hotels
Avg. S&P 500 Stock
6
15
2
57
52
61
Note: Quadrix scores are percentile ranks, with 100 the best.

We like stocks with strong recent returns, but we like them a lot more if they also boast the strong fundamentals needed to earn a high Overall score. And even more if they aren't too expensive. The table above lists stocks that satisfied our screen, three of which are reviewed below.

There is a very short list of stocks that can singlehandedly cause the market to hold its breath. At the top of that list is Apple ($582; APPL), with a market capitalization of $543 billion. To put Apple's sheer size into context, the stock accounts for more than 4% of the market value of the S&P 500 Index and is about as large as IBM ($208; IBM), Wal-Mart Stores ($59; WMT), and PepsiCo ($66; PEP) combined.

When Apple topped the March-quarter profit consensus by 23% on April 24, it breathed life into an earnings season long on profit surprises but short on enthusiasm. While Apple projected June-quarter profits well below the consensus, analyst estimates have actually risen since the announcement, reflecting Apple's history of issuing conservative guidance.

Over the last year, Apple's profits and operating cash flow have roughly doubled, outpacing its share-price gain of 68%. Apple shares trade at 14 times trailing earnings, 25% below the three-year average P/E. Apple is a Focus List Buy and a Long-Term Buy.


UnitedHealth Group ($57; UNH) earns a Performance score of 81, among the highest in the managed-care group. The shares have risen 24% over the last six months.

The consensus projects per-share-profit growth of 5% this year and 11% next year, targets that sound conservative considering improvements in the labor market and the accompanying enrollment gains. UnitedHealth has topped profit expectations by at least 12% in each of the last two quarters. The consensus profit target for 2012 has risen 3% over the last 30 days, while the 2013 target has increased 2%, aided by the company's higher guidance in the wake of solid March-quarter results.

In the March quarter, UnitedHealth's enrollment (excluding Medicare Part D clients) neared 36 million, up 2.8% from the end of 2011 and 4.6% from a year earlier. A combination of enrollment gains, aggressive cost controls, and a share-buyback plan (share count down 4% over the last year and 24% over the last five) give us confidence in the company's ability to meet its long-term per-share-profit growth target of 13% to 16%. UnitedHealth is a Buy and a Long-Term Buy.


Over the last six months, shares of hotel and timeshare operator Wyndham Worldwide ($51; WYN) have risen 57%, more than triple the gain of the S&P 1500 Consumer Discretionary Sector Index. Such outperformance makes sense when you consider Wyndham's operating momentum. In the 12 months ended March, per-share profits increased 35% and operating cash flow jumped 52%.

Revenue per available room rose 7% in 2011 to $33.34, the highest annual rate since 2008, then followed up with another 7% gain in the March quarter. Rising demand for hotel rooms has both boosted occupancy rates and supported price hikes, trends that should continue in the year ahead. The consensus projects per-share-profit growth of 22% this year and 14% next year. Wyndham is a Focus List Buy and a Long-Term Buy.


Over long term, laggards take lead

Everybody likes a winner.

We tend to be more confident in long-term leaders than in laggards. And we probably shouldn't be. In a back-test of 12-month returns since 1990, the one-fifth of the S&P 500 Index with the highest average three- or five-year total returns substantially underperformed stocks with the weakest returns.

Conversely, stocks that have underperformed over three- and five-year periods tend to outperform over the next 12 months. In fact, while our Quadrix Performance score rewards companies for outperformance during periods of 12 months or less, it favors laggards over longer periods.

For example: Portfolios containing only stocks found in both the top one-fifth of the index as measured by six-month total returns and the bottom one-fifth based on three-year total returns averaged 12-month returns of 16.9%, versus 12.7% for the average stock in the index.


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