It's OK To Be Picky
Anglers use fishfinders to identify promising spots for their next big haul. Our edge is Quadrix, a quantitative system that squeezes dozens of factors into a single Overall score. In back-tests, stocks scoring above 80 for Overall have outperformed the average S&P 1500 stock by an average of 2.3% in 12-month periods since 1994.
The Overall score serves as a net, screening out stocks likely to produce minnow-sized returns — or worse, sink a portfolio. But we calculate percentile ranks that compare more than 4,600 stocks, and even limiting ourselves to high scorers leaves hundreds of candidates to sift. To winnow that field to a manageable group for additional analysis, we often use the following three strategies:
• Sector-specific scores augment traditional Quadrix scores, generating ranks that take into account the peculiarities of each sector. The 12-Factor Sector score considers a dozen individual statistics that work particularly well in a sector. The Reranked Overall applies the same six Quadrix categories that comprise the Overall score but reweights them according to their effectiveness for each sector.
• Threshold analysis measures a stock's broad strength in Quadrix by considering the percentage of individual factors exceeding a certain level. In this case, we screened for stocks scoring above 60 in at least 50% of the dozens of individual factors. Our back-tests indicate that stocks tend to perform best when their Overall scores are supported by strength in a high percentage of individual factors.
• Persistence considers the consistency of a stock's Overall rank. Stocks that routinely score above 80 Overall tend to earn steady scores going forward. More importantly, these stocks tend to outperform their high-scoring peers with more volatile scores.
We prefer our recommended stocks to earn high Overall scores and also satisfy the three criteria above. But such stocks can be rare. As above, just 23 companies in the S&P 1500 Index meet our requirements in all four areas. That field narrows to 12 stocks after eliminating companies with stock-market values below $4 billion — the smallest stocks we typically consider for the Forecasts buy lists. We recommend seven of those 12 stocks, as shown in the table below. Six favorites are reviewed below.
Aflac ($62; AFL) earns an Overall score of 96, paced by a Value score of 97, and 56% of its individual Quadrix statistics earn ranks above 60. At 9.5 times trailing earnings, Aflac trades at a 16% discount to the median life & health insurer — an industry long known for unusually low P/E ratios — and 17% below its own five-year average. The company looks even cheaper relative to cash flow, trading at just 2.2 times 12-month trailing cash provided by operations and 2.3 times free cash flow, well below industry medians of 6.2 and 6.9, respectively.
Over the last 12 months, the insurer has grown per-share profits 32% on 6% sales growth. However, expectations are low, with the consensus projecting a per-share-profit decline of 11% in the second half of 2013, followed by a 5% gain next year. Aflac, a Buy and a Long-Term Buy, seems capable of exceeding profit targets.
Apple ($455; AAPL) shares have slipped 11% since the unveiling of two new iPhones, as investors remain unconvinced the company can revive sales in emerging markets. The price tag on the iPhone 5C, Apple's more colorful and less expensive model, is still relatively high. The 5C's price redoubles Apple's reliance on hefty carrier subsidies, which are less prevalent abroad. Still, a higher price eases some concerns that profit margins will take a hit like they did with the iPad Mini's release. Perhaps just as worrisome, Apple strayed from tradition by neglecting to report the number of iPhone 5C preorders in its initial weekend.
But the stock remains a favorite in Quadrix, where 45% of its factors score above 80 and nearly one-fourth exceed 90. The Overall score has risen to 96, helped by improving earnings-estimate-revision trends. Apple is a Buy and a Long-Term Buy.
Almost 39% of Cognizant Technology Solutions' ($81; CTSH) Quadrix factors exceed 80, a feat accomplished by fewer than 9% of the stocks in our research universe of more than 4,600 companies. Those high-ranking factors are clustered in the following three categories: Quality (57% of factors above 80), Value (48%), and Financial Strength (45%). The stock also looks strong elsewhere. Shares have surged 29% since we first recommended them in late June, helped by strong June-quarter profits and receding worries about the effects of immigration reform on Cognizant's business.
In the first half of 2013, Cognizant reported broad growth in its consulting and outsourcing businesses, the result of higher discretionary spending by its clients. Management expects discretionary spending to remain strong for the remainder of 2013. The consensus projects per-share profits will rise 12% and sales 19% in the second half of the year. Cognizant is a Focus List Buy and a Long-Term Buy.
Magna International ($84; MGA), a maker of automotive systems for most major car manufacturers, occupies an enviable spot as the U.S. auto market shifts into high gear. In August, U.S. car sales accelerated to the fastest pace since before the recession. Rising analyst estimates call for Magna to earn $1.32 per share in the September quarter, up 17%.
The stock earns an Overall rank of 98 and the maximum Reranked Overall score of 100, with 30% of its individual factors exceeding 80. Of course, not all Quadrix factors merit equal attention. For instance, Magna scores above 80 for price/sales ratio, the most effective Quadrix factor in the past five years. Twelve-month returns for S&P 1500 stocks scoring above 80 for price/sales ratio exceeded the index's average return by an average of 6.5% over the past five years. Magna is a Focus List Buy and a Long-Term Buy.
Qualcomm ($69; QCOM) has delivered strong growth for sales and cash flow in recent quarters. In addition, return on assets has risen to its highest level since the September 2008 quarter. At 16 times trailing earnings, shares trade 28% below their five-year average and 21% below the median S&P 1500 communications-equipment stock. Nearly 70% of Qualcomm's Quadrix factors exceed 60.
Robust operating momentum has given management confidence to share more of its cash with stockholders. Earlier this month Qualcomm announced a fresh $5 billion stock-buyback plan, replacing a $5 billion plan announced in March that had $800 million remaining. Midway through September, Qualcomm said it had spent about $3.2 billion on buybacks so far in the quarter. The company says it has returned $25 billion to shareholders through dividends and buybacks since 2003. Qualcomm is a Focus List Buy and a Long-Term Buy.
Wells Fargo's ($43; WFC) management adopted a bullish posture this summer, saying the company stands to capitalize on the improving economy, even though rising interest rates may crimp short-term momentum for its mortgage business. The stock has earned an Overall rank of at least 95 in six straight months, helped by all six category scores consistently exceeding 60.
The stock, returning 28% so far this year, trades within 4% of its all-time high. But at less than 12 times trailing earnings, Wells Fargo trades 26% below its five-year average and 24% below the median for S&P 1500 bank stocks. Wells Fargo, scoring above 95 for both sector-specific ranks, is a Focus List Buy and a Long-Term Buy.