Quadrix in a group setting

9/15/2008


Many subscribers have asked why the Forecasts doesn’t recommend the purchase or sale of entire sectors within the stock market.

The chief reason is simple — our Quadrix® rating system and stock-picking approach are built around individual companies. We don’t target sectors, then move on to stock selection. Instead, we search for stocks we like, and those stocks lead us to invest more heavily in certain sectors.

In addition, it is risky to advise the purchase or avoidance of an entire sector or group, for several reasons:

Not every stock in a sector is the same. Many industry groups contain drastically different companies. Companies in such groups as consumer services and capital goods produce widely divergent products and target different markets. As such, an environment friendly to some firms may prove less hospitable to others.

Similar stocks may provide different returns. Even in an industry group in which most companies do the same job, stock performance can diverge. When some investors hear we like Johnson & Johnson ($71; NYSE: JNJ), they figure they can earn similar returns with any large-capitalization drugmaker. Such assumptions are dangerous. No quantitative system can take into account the state of the companies’ drug pipelines or assess the danger of patent expirations.

Quadrix doesn’t work well for all groups. No quantitative system is perfect. While declining scores in the banking group in 2007 provided a warning of impending doom, real-estate scores remained solid.

For the reasons listed above, subscribers should be cautious about buying or selling entire sectors or industries. However, we acknowledge that sector calls can add a lot of value, and our bottom-up approach has a good record of identifying attractive groups. Since 1994, focusing on groups with the highest average Quadrix Overall score has been a market-beating strategy.

A portfolio consisting of equal-weighted positions in the three top-scoring groups in the S&P 1500 Index averaged a 16.2% return in a back-test of rolling 12-month periods since December 1994, as shown in the chart below. In contrast, a portfolio consisting of equal-weighted positions in all groups averaged a 13.7% return. A strategy of owning only the top-scoring group yielded an average return of 20.9%.

Because Quadrix works better in some groups than in others, targeting individual groups can be problematic. To improve the odds, we looked at more than 13 years of historical returns to determine the groups for which Quadrix had the most predictive power. Some, such as capital goods and health-care equipment & services, earn high Overall scores. Others, such as banks and diversified financials, have poor scores.

Aerospace & defense
Increased defense spending has helped drive strong results at General Dynamics ($85; NYSE: GD). Over the last three years, sales rose at an annualized rate of 13%, while per-share profits grew at a 23% clip. The company makes military ships and armored vehicles for the U.S. government (two-thirds of total company sales) and foreign governments. As one of two main U.S. manufacturers of warships, General Dynamics should see business grow over the next several years, as the U.S. Navy plans to spend heavily on new vessels.

General Dynamics also makes private jets for corporations and wealthy individuals, and the aerospace division has delivered impressive gains in recent quarters. The company said orders for its newest jet, the Gulfstream G650, have been pouring in. However, a rise in the inventory of used jets for sale in August suggests orders could slow in the near term.

Consensus estimates for 2008 and 2009 have been trending upward over the last three months and project per-share-profit growth of 20% this year and 9% next year. General Dynamics is a Buy and a Long-Term Buy.

Application software
Adobe Systems ($41; NASDAQ: ADBE) is reporting strong demand in international markets. The software developer generates more than half of its revenue overseas, and solid foreign sales are helping to offset weakness in the U.S. While demand overseas is likely to remain steady, the recent rise of the U.S. dollar could affect growth rates. Currency gains have boosted sales in recent quarters, a trend likely to reverse over the next year. By one estimate, currency translation could reduce fiscal 2009 profits by about 2%. Adobe has several new products slated for launch over the next few months, and the consensus projection of a 13% increase in per-share profits for the year ending November 2009 seems conservative.

Adobe targets creative professionals with products that tap into high-growth markets. For example, Adobe’s Flash is used to create video for the Internet, while Photoshop is a market leader in editing digital photography. Both Internet video and digital photography have gained popularity in recent years, and global demand for digital content continues to rise. Adobe’s mobile and device division is small, but the company hopes to expand rapidly by launching new products. Adobe is a Buy and a Long-Term Buy.

Systems software
Despite the weak economy, Oracle ($19; NASDAQ: ORCL) is performing well. In the fiscal year ended May, sales rose 24% while per-share profits jumped 29%. Management said the business pipeline for the next year looks solid, but some analysts have lowered August-quarter estimates, citing tough year-to-year comparisons and potential currency losses. Oracle is slated to release August-quarter results Sept. 18. Wall Street expects 15% growth in per-share profits in fiscal 2009 and 2010, targets Oracle should be able to match or exceed.

Over the last several years, Oracle has expanded beyond its core business of database software into enterprise software used to manage large businesses. Acquisitions have bolstered Oracle’s product offerings and customer base, creating opportunities to cross-sell other Oracle products.

Oracle’s success revolves around creating groups of industry-specific products that work together efficiently to address all of a customer’s information-technology needs. This interoperability helps discourage customers from switching to competing products and encourages them to add new products from Oracle’s lineup. Oracle is a Buy and a Long-Term Buy.

 

GROUPS FOR WHICH QUADRIX WORKS
Below are the nine S&P 1500 groups for which Quadrix® scores are most highly correlated with future returns. Stocks in these groups tend to deliver stronger returns after periods when average Quadrix Overall scores for the group are high, and weaker returns when scores are low. All data except the company count are averages.
—————————— Quadrix Scores * ——————————
12-Mo.
— Change —
Est. 5-Yr.
EPS
Chg.
(Ann.)
(%)
Total
–— Return –—
Group (Company Count)
Momen-
tum
Value
Quality
Fin'l
Str.
Earns.
Ests.
Perfor-
mance
Overall
Trailing
P/E
Sales
(%)
EPS
(%)
6
Mos.
(%)
12
Mos.
(%)
Capital Goods (128)
66
63
70
60
62
61
74
15
14
16
14
3
(9)
Health-Care Equip.
& Svcs. (114)
63
50
66
60
56
65
65
21
15
13
16
11
(3)
Software & Services (96)
60
50
65
67
50
58
64
20
17
15
16
4
(10)
Retailing (95)
44
63
59
61
50
60
60
18
6
(3)
14
10
(12)
Consumer Services (60)
51
59
62
56
48
52
60
22
10
(1)
17
4
(21)
Semiconductors &
Equipment (56)
48
47
59
69
43
46
55
20
7
3
16
(4)
(27)
Diversified Financials (50)
36
57
64
60
37
55
55
17
10
3
13
(5)
(18)
Consumer Durables
& Apparel (73)
39
59
47
46
45
58
50
16
0
(3)
14
5
(13)
Banks (89)
26
55
40
49
35
50
38
15
2
(18)
8
(13)
(27)
Notes: Averages exclude P/E ratios below 0 or over 75 and growth rates of more than 100%.      * Percentile ranks, with 100 the best.

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