What Works Best On Wall Street

2/9/2009


Our Quadrix® stock-rating system is designed to reward stocks with broad-based appeal. Because the Overall score depends on more than 80 metrics divided among six categories, a stock needs to score well in several areas to earn top marks.

Still, subscribers often ask us for the single most effective metric in Quadrix. To answer such questions — and spotlight stocks particularly appealing based on highly effective metrics — we evaluated the historical returns of top scorers based on every metric used in Quadrix.

As it turns out, identifying the single best metric is no easy task, as some variables work better for some stock universes than for others. Even defining “best” is not so simple, as returns can be measured in a variety of ways. To get around such issues we used a composite approach, evaluating the returns of top Quadrix scorers for stocks in six well-known indexes. We also measured effectiveness five different ways:

Average return. Using rolling 12-month returns since 1994, we calculated the simple average return of the top one-fifth of stocks based on every Quadrix metric.

Median return. Using the same methodology as above, we calculated median returns. By definition, one-half of 12-month returns were above the median while one-half were below.

Geometric average. With 12-month periods, geometric average is equivalent to annual compound return. Unlike the simple average, geometric average takes into account the compounding of gains on gains. For example, the geometric average for two periods with returns of 10% and 50% is 28.45%. A dollar would grow to $1.10 after a gain of 10%, then $1.10 would grow to $1.65 with a gain of 50%. With gains of 28.45% in both years, a dollar would grow to $1.65. If returns are constant, geometric average and simple average are equivalent. As returns become more volatile, geometric average will fall relative to simple average.

Winning percentage measures the percentage of 12-month periods in which the top one-fifth of stocks delivered positive returns.

Average return divided by standard deviation. Standard deviation measures the volatility of returns, so this ratio approximates return per unit of risk.

Assigning equal importance to each of these five measurements, seven metrics consistently rank among the top performers: Overall score, earnings per share revisions for the current quarter, earnings per share revisions for the next quarter, enterprise value/EBITDA ratio, price/earnings ratio, price/cash flow ratio, and price/free cash flow ratio.

Listed in the table below and reviewed in the following paragraphs are stocks with outstanding scores in at least one of these seven metrics. All 14 stocks in the table earn Overall scores of at least 80, meaning they rank among the top one-fifth of U.S.-traded stocks based on the most important and broad-based Quadrix metric.

A deep drug pipeline and the potential of Tysabri, a multiple sclerosis treatment, have helped Biogen Idec ($52; BIIB) gain traction with analysts. Over the past month, analysts have raised profit estimates for both the December and March quarters. As a result, the stock ranks among the top 6% of stocks for earnings revisions in both the current quarter and the next quarter.

Consensus estimates project per-share earnings will rise 3% in the December quarter and 17% in the March quarter, but the company has exceeded consensus estimates for four straight quarters. For 2009, the consensus estimate of 9% earnings growth seems conservative.

A rival announced plans to seek approval in 2009 to market the first multiple sclerosis pill. Despite the potential for new competition, Biogen shares appear positioned for year-ahead gains. Biogen trades at 17 times trailing earnings, a reasonable valuation considering its operating momentum. Biogen, which was expected to report December-quarter results Feb. 6, is a Focus List Buy and a Long-Term Buy.

 


Harris ($43; HRS) earns an Overall Quadrix score of 96. While the stock does not rank as a true standout on any of the six individual metrics identified as highly effective, broad-based strength means the stock scores no lower than 54 in any of the six Quadrix category scores. The Pentagon’s 2010 spending plan, drafted under the Bush administration, is about 13% higher than the current budget of about $511 billion. This might ultimately prove wishful thinking, as budget cuts are likely.

Fortunately for Harris, it operates in the communication niche, a less-likely target for cutbacks. Moreover, Harris provides many of the tactical radios used in Afghanistan, an area President Obama considers strategically important. Wall Street estimates for Harris have held steady, projecting per-share profits will grow 21% in fiscal 2009 ending June and another 11% in fiscal 2010. December-quarter earnings for Harris, a Focus List Buy and a Long-Term Buy, are presented in Portfolio Review.

 


With a stock price that has followed the swoon in crude oil and a cash position more than double its debt, National Oilwell Varco ($26; NOV) scores better than about 87% of U.S. stocks for enterprise value/EBITDA ratio — one of the best metrics for predicting year-ahead performance. Enterprise value is the sum of stock-market value and debt, minus any cash. EBITDA equals earnings before interest expense, taxes, depreciation, and amortization.

National Oilwell ranks even better for price/earnings ratio, as its trailing P/E of five is cheaper than that of about 88% of U.S. stocks. Adding to the stock’s appeal as value play, National Oilwell earns solid scores for price/cash flow ratio and price/free cash flow ratio — and a massive backlog seems likely to sustain healthy cash flow.

In the December quarter, National Oilwell earned $1.44 per share excluding merger-related charges, up 37% and $0.11 better than the consensus. Revenue climbed 43% to $3.81 billion, and gross profit margin increased nearly two percentage points to 31.7%. The backlog of $11.1 billion is equal to more than 80% of annual revenue, and the company says only 3% of that backlog is at risk of default. National Oilwell is a Buy and a Long-Term Buy.

 


Transocean ($54; RIG) earns a rank of 95 for P/E ratio, as the stock trades at just three times trailing earnings. Trailing per-share earnings have surged 81% in the past four quarters, while the stock has dropped 67% from May highs as oil prices slumped. The stock trades at three times trailing cash flow, earning a Quadrix rank of 86.

Transocean, with a fleet of deepwater drilling rigs, could post another year of record earnings in 2009. Consensus estimates project per-share earnings will reach $14.79 in 2009, up 3% from the $14.34 expected for 2008. For the December quarter, due Feb. 17, the consensus anticipates earnings of $3.71 per share, up 9%.

The bulk of the fleet is committed to large multinationals — mostly well-capitalized companies unlikely to cancel contracts. For example, Brazilian oil giant Petrobras Energias ($27; PBR) recently affirmed plans to continue spending on deepwater projects. The shallow-water market is weaker but also represents a narrowing slice of Transocean’s business (an estimated 30% of this year’s total contract revenue). Transocean is a Focus List Buy and a Long-Term Buy.

 


Western Digital ($15; WDC), a maker of computer hard drives, trades at five times trailing free cash flow, lower than about 83% of
U.S.-traded stocks. The strong cash flow has helped lift the cash position to $1.38 billion, or almost three times total debt on Dec. 31. Western Digital also stands out on such valuation ratios as price/cash flow (rank of 89), P/E (rank of 97), and enterprise
value/EBITDA (rank of 97).

Western Digital posted per-share profits of $0.55 in the December quarter, down 59% but $0.24 higher than the consensus. Revenue fell 21% but exceeded expectations on a 4% increase in units shipped. The outlook for the March quarter appears bleak, with consensus forecasts projecting per-share earnings will be down 89%. However, Western Digital has surprised analysts by shifting into areas outside of standard personal computers. Western Digital is a Buy.

 

QUADRIX STANDOUTS ON HIGHLY EFFECTIVE METRICS
———— EPS Revisions ————
Current
—– Quarter –—
Next
—– Quarter –—
Enterprise
Value/EBITDA
Price/Earnings
—— Ratio ——
Price/Cash
—— Flow ——
Price/Free
— Cash Flow —
Company
(Price; Ticker)
Quadrix
Overall
Score *
Rank
Value
(%)
Rank
Value
(%)
Rank
Ratio
Rank
Ratio
Rank
Ratio
Rank
Ratio
Advice
Amgen
($57; AMGN)
86
92
5.6
96
25.0
30
9
39
14
30
11
NA
NA
Neutral
Biogen Idec
($52; BIIB)
97
94
13.6
96
25.0
41
8
28
17
25
12
48
12
Focus
Buy †
BMC Software
($26; BMC)
84
95
18.2
68
0.0
39
8
28
17
25
12
55
11
Neutral
Chevron
($72; CVX)
94
96
23.1
14
(50.0)
87
3
81
6
75
5
28
20
Buy †
DirecTV
($23; DTV)
89
92
5.9
98
50.0
63
5
29
17
56
7
39
15
Focus
Buy †
Energen
($30; EGN)
80
23
(28.6)
14
(50.0)
83
4
82
6
78
4
NA
NA
Long-
Term Buy
Garmin
($17; GRMN)
99
93
10.0
37
(15.4)
85
3
88
5
78
4
68
8
Neutral
Harris
($43; HRS)
94
69
0.0
68
0.0
53
6
59
10
32
10
28
20
Focus
Buy †
Humana
($43; HUM)
87
92
5.9
68
0.0
97
1
68
9
49
8
17
30
Neutral
IBM
($93; IBM)
87
92
7.1
99
80.0
51
6
61
10
50
7
NA
NA
Focus
Buy †
National Oilwell
($26; NOV)
98
26
(25.0)
21
(36.4)
87
3
88
5
65
6
74
7
Buy †
NII Holdings
($19; NIHD)
89
43
(8.3)
29
(25.0)
86
3
82
6
80
4
4
84
Focus
Buy
Transocean
($54; RIG)
91
40
(11.4)
26
(32.0)
75
4
95
3
86
3
0
-3
Focus
Buy †
Western Digital
($15; WDC)
85
28
(23.1)
29
(25.0)
97
1
97
2
89
3
83
5
Buy
* Quadrix scores are percentile ranks, with 100 the best.      † Also qualifies as a Long-Term Buy.      NA Not available.

 


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