Use Quadrix Just Like We Do

11/26/2012


We have written quite a bit about the merits of our Quadrix stock-rating system and how it can help identify stocks likely to outperform in the year ahead. But we've devoted far less space to explaining how we use the system — and how you as a Dow Theory Forecasts subscriber can use the same approach.

In the following paragraphs, we present the hows and whys, revealing a three-step strategy for tapping into the power of Quadrix.

Step 1 – Skim the cream

Quadrix considers more than 80 statistics in six categories, assigning percentile ranks to more than 4,500 U.S.-traded stocks. In back-tests since the end of 1994 and real-world usage since 2000, stocks with high Quadrix Overall scores have outperformed stocks with low scores.

In the last 203 rolling 12-month periods, S&P 1500 Index stocks with Overall scores of 80 or more have averaged returns of 15.0%, well above the average of 12.6% for all stocks in the index. Those high-scoring stocks generated positive returns in 81% of the periods, versus 77% for the average stock, and outperformed the average stock in 72% of the periods.

The higher you set the bar, the better the returns, to the point that stocks scoring at least 98 Overall averaged 12-month returns of 19.2%, fully 6.6% above the average stock's return. We require all new buys to score at least 80 Overall but prefer stocks earning at least 90.

Step 2 – Compare to sector

While Quadrix is designed to rank stocks relative to all the others in our universe, we also developed sector-specific scores to compare stocks only within their sector. This matters because differences between sectors can complicate the comparison.

For example: Energy stocks as a group sport lower price/earnings and other valuation ratios than most stocks. Not surprisingly, the S&P 1500's energy stocks average Value scores of 60, versus 48 for consumer staples.

An energy stock that looks cheap relative to consumer-staples stocks might not look so attractive next to its peers. In addition, not all Quadrix categories work well in all sectors, as illustrated in the table below. Our sector-specific scores look at stocks from different angles, and top scorers tend to outperform other stocks in their sector.

SECTOR SCORES HAVE POWER
Back-Tested Outperformance Of Top One-Fifth Of S&P 1500 Sector Based On . . .
Sector Scores
---------------------------- Quadrix Scores ----------------------------
Sector
12-
Factor
Sector
(%)
Reranked
Overall
(%)
Overall
(%)
Momen-
tum
(%)
Value
(%)
Quality
(%)
Fin'l
Str.
(%)
Earns.
Ests.
(%)
Perfor-
mance
(%)
Cons.
Discretionary
8.6
5.2
4.4
2.5
2.2
1.9
(0.3)
0.6
0.7
Consumer
Staples
5.5
2.4
(0.6)
1.2
2.4
0.1
(1.8)
0.1
(1.3)
Energy
4.3
1.6
0.7
(0.9)
2.2
0.7
(0.7)
0.9
(0.9)
Financials
5.1
4.6
2.2
1.2
4.6
1.2
(0.2)
0.1
(0.6)
Health Care
6.5
3.0
0.1
0.2
2.3
(1.0)
(1.0)
(0.5)
0.2
Industrials
5.2
1.5
(0.9)
(1.7)
2.1
(2.0)
(1.8)
(1.3)
(1.4)
Materials
6.1
6.9
3.7
0.3
6.4
2.4
1.4
2.7
0.8
Technology
11.0
3.9
3.4
(0.7)
1.4
3.1
1.6
(1.6)
(0.5)
Telecom
8.9
5.3
(1.4)
1.2
4.6
(4.3)
(6.3)
(0.1)
(1.2)
Utilities
2.3
1.5
0.2
0.4
2.2
(0.9)
(0.5)
0.1
0.2

The 12-Factor Sector score is based on a dozen statistics that work well within a given sector. Each score uses different metrics, customized for that sector. The Reranked Overall score starts with the same six category scores that derive the traditional Overall score but assigns them more or less weight based on how well they work in a specific sector.

We use the sector scores as a check on Quadrix. If a high Overall scorer also earns solid sector-specific scores, we gain confidence in the stock.

Step 3 – Get in close

Despite Quadrix's power, we never take an Overall score at face value. Think of the Overall score as a first screen, eliminating most stocks immediately. Once we scoop the best scorers off the top of the basket, we look for signs of trouble, including:

Scores below 20 in Earnings Estimates or Performance, the categories most sensitive to short-term trends. Performance considers stock returns, mostly for periods of 12 months or less, while Earnings Estimates reflects changes in analyst profit estimates. We might recommend a stock despite an extremely low score in Earnings Estimates or Performance, but we'd need a strong reason to buck the trend.

Trends the numbers don't yet reflect. Quadrix, like all quantitative systems, can only consider information already baked into the statistics. Does a new rival or product threaten a company's business, or will regulatory changes hurt its profitability? Individual company analysis helps us determine whether Quadrix is telling the whole story.

Recent events. Suppose a company posts an ugly quarter and drastically cuts its profit guidance? The news could lower scores for Momentum (recent operating results) and Earnings Estimates — but not until our weekly Quadrix run on Thursdays.

The above issues, as well as many others, might cause us to pass on a stock with high Quadrix scores or stick with one despite falling scores.

Quadrix is the linchpin of our stock-selection strategy. If you enjoy analyzing stocks, Quadrix can help. Below you'll find a list of resources on our website. If you prefer to let us select stocks for you, skip to the table below, which presents 14 stocks with strong Quadrix scores and exceptional year-ahead total-return potential.

Aflac ($51; AFL) earns 100 Overall, the maximum possible score, and at least 94 in both sector-specific ranks. All six of the stock's category scores top 75, a feat accomplished by only 14 other stocks in our research universe, reflecting broad-based fundamental strength.

The insurer enjoys excellent operating momentum, growing sales at least 12% and per-share operating profit at least 27% in each of the last four quarters. Aflac generated operating cash flow of $14.81 billion over the last 12 months, up 54% from the same period a year ago. Such growth warrants a premium price, but Aflac trades at less than eight times trailing earnings, a 34% discount to its three-year average. The shares also trade at least 11% below their three-year average price/sales, price/operating cash flow, and price/book ratios.

Aflac sells supplemental health and life insurance in Japan (80% of earnings) and the U.S. (20%). Japan has generated much of Aflac's growth in recent quarters, with new annualized premium sales hitting a new record in each of the last five quarters. The rising consensus projects profit growth of 5% in 2013 for Aflac, a Focus List Buy and a Long-Term Buy.


Americans' increasing enthusiasm for exercise has contributed to the health of shoe retailer Foot Locker ($34; FL). Demand for athletic shoes remains high despite the lackluster economic recovery. In the October quarter, profits rose 47% to $0.63 per share excluding a foreign tax settlement, $0.09 above the consensus. Sales rose 9%, with same-store sales up 10.2%.

Foot Locker's focus on improving productivity has boosted margins in recent quarters and continues to pay off, with the company turning over inventory more quickly and generating higher sales per square foot in the October quarter.

Operating profit margins reached 11.6% in the 12 months ended in October, up from 9.5% in the same period a year earlier and 6.5% the year before that. Foot Locker has fattened its margins by shifting the sales mix toward higher-priced shoes, controlling operating costs (up just 2% annually over the last three years, versus 6% sales growth), and tightening its inventory management, which should reduce the need for markdowns and promotions. Foot Locker is a Focus List Buy and a Long-Term Buy.


Shares of Thermo Fisher Scientific ($61; TMO) have risen nearly 7% since the maker of analytic and laboratory tools announced September-quarter profits that topped the consensus and optimistic guidance. The consensus projects per-share-profit growth of 8% in the December quarter and 11% next year, and estimates are trending higher.

Thermo Fisher is taking share in the mass-spectrometry market, augmenting that growth with expansion in emerging markets (sales rose more than 20% in China in the September quarter) and niche acquisitions. The company has announced 16 acquisitions since 2009, including three this year, most recently the September announcement of plans to purchase One Lambda, a maker of transplant diagnostics with about $180 million in annual revenue.

While the median maker of life-science tools trades at 16 times trailing earnings, you need only pay 13 times earnings for Thermo Fisher. The stock also trades at a discount to its own historical norms for price/earnings, price/sales, and price/operating cash flow. Thermo Fisher Scientific, which raised its dividend 15% earlier this month, is a Focus List Buy and a Long-Term Buy.

SCREEN OF THE MONTH: BUYS WITH STRONG QUADRIX SCORES
The 14 Buy-rated stocks below earn Quadrix Overall scores of at least 80 and score in the top one-third of their sector in both of our sector-specific scores. To screen out companies with near-term weakness, we did not allow Quadrix Earnings Estimates or Performance scores below 20.
--------------------------------- Quadrix Scores ---------------------------------
--- Sector Scores ---
Company (Price; Ticker)
Momen-
tum
Value
Quality
Fin'l
Str.
Earns.
Ests.
Perfor-
mance
Overall
12-
Factor
Sector

Reranked
Overall

Sector
Aflac ($51; AFL)
90
97
89
78
87
86
100
94
100
Financials
American Express
($55; AXP)
72
75
70
57
52
38
80
79
80
Financials
CF Industries
($204; CF)
88
93
99
92
89
62
100
95
100
Materials
Cisco Systems
($18; CSCO)
79
91
75
80
36
57
94
86
96
Technology
CVS Caremark
($45; CVS)
69
62
79
54
87
61
85
95
89
Consumer Staples
DirecTV ($49; DTV)
80
89
98
59
40
40
96
87
88
Cons. Discretionary
Foot Locker ($34; FL)
89
69
82
68
77
60
94
69
93
Cons. Discretionary
Macy's ($41; M)
71
73
72
38
70
68
86
89
84
Cons. Discretionary
Qualcomm
($62; QCOM)
78
43
90
97
93
59
88
82
86
Technology
Thermo Fisher
($61; TMO)
85
65
74
51
89
86
93
92
93
Health Care
U.S. Bancorp
($32; USB)
90
68
57
99
91
54
91
78
85
Financials
UnitedHealth
($53; UNH)
65
80
83
54
56
42
87
73
90
Health Care
Visa ($146; V)
86
26
94
92
85
91
86
93
88
Technology
Wells Fargo
($32; WFC)
81
86
53
77
73
49
90
97
89
Financials
Note: Quadrix and sector-specific scores are percentile ranks, with 100 the best.

On the web

Like to do your own research? You can tap into the power of Quadrix. Here are some particularly useful destinations:

• For more information on the Overall score and its six component categories, visit www.DowTheory.com/Go/Explain.

• For sector-specific scores on more than 1,500 stocks, visit www.DowTheory.com/Go/Sectors. To compare Quadrix scores for up to 100 different stocks, try www.DowTheory.com/Go/Compare.

• At www.DowTheory.com/Go/Groups you can find average Quadrix scores for stocks in more than 150 industries, then drill down to the company level.


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