Seeking Quality Assurance

3/31/2014


Great companies do not always make great investments. And the Quadrix Quality score — our quantitative tool that identifies companies with superior growth rates, profit margins, and returns on investment — does not always work well.

Among the six Quadrix categories, Quality ranks fifth since January 1990, with top scorers among the S&P 500 Index averaging a modest 0.2% excess 12-month return. It has been the worst Quadrix category over the past 12 rolling 12-month periods, with the top quintile (one-fifth) underperforming by an average of 6.7%. In contrast, Value has dominated during that stretch, outperforming by 10.9%.

Quality often works when Value lags — and vice versa. When fears of a downturn arise, investors tend to favor quality stocks — companies with consistent growth and high profitability that seem capable of withstanding potential troubles ahead. Once the economy appears to be stabilizing, investors tend to rotate out of high-quality names and into cheaper or riskier stocks.

Quality's recent underperformance shows that even the best-run companies can become poor investments, especially if bought at too high a price. Nevertheless, finding stocks with steady operating growth and high returns on assets, equity, and investment is an important component of our stock-selection process, which seeks high quality — in addition to other types of appeal. Just one of our 40 recommended stocks earns a below-average score for Quality. On our Focus List, 80% of constituents score of at least 80 for Quality.

Why do we place such emphasis on Quality when it doesn't work very well? Because we're using Quality in concert with five other categories — especially Value, which receives the biggest weighting in the calculation of Overall Quadrix scores. By emphasizing high-quality stocks with attractive valuations, we capture much of the Value score's outperformance — without its huge swings in relative returns.

Since the start of 1990, top Quadrix Overall scorers have averaged 12-month outperformance of 2.5% versus 3.4% for Value, both dwarfing Quality's 0.2%. Based on the variation in relative returns, top Overall scorers were about 60% as volatile as top Value scorers.

The table below highlights 10 stocks that stand out based on multiple quality measurements. Equally important, they seem reasonably priced, earning Value scores above 50. Below, we review four of our favorites.

Apple ($545; AAPL), the biggest U.S. company by stock-market value and net income, scores above 80 in more than 70% of its individual Quality factors, earning a category score of 99. Although Apple's cash from operations rose 6% to a record-high of $53.67 billion in fiscal 2013 ended September, the year was the first since 2003 in which Apple failed to grow earnings per share and revenue by at least 24%. Annual operating profit margins fell for the first time in a decade.

The competition in mobile devices has caught up to Apple, which has recently made incremental improvements to existing products rather than launching new product categories. Investors await the next big thing: whether it's a transformative TV product, smartwatch, or health-monitoring device. But Apple's explosive growth in recent years has created a problem shared by some energy giants: It's getting increasingly difficult and expensive to move the revenue needle.

Apple may never return to its accelerated growth rate over the past decade, though it seems capable of at least meeting consensus targets of 8% higher earnings per share on 6% sales growth in both fiscal 2014 and 2015. At 14 times trailing earnings, Apple shares trades 35% below the median for S&P 1500 technology stocks. Apple, yielding 2.3%, is a Buy and a Long-Term Buy.


Although CVS Caremark ($75; CVS) reported a 13% decline in cash from operations in 2013, revenue and earnings per share reached record highs. Returns on assets, equity, and investment are at six-year highs. The company has grown its per-share dividend at an annualized rate of 28% over the past five years, ranking in the top 6% of our research universe. CVS is set to return 25% of earnings through dividends this year, following a 22% hike announced in December. It expects the payout ratio to reach 35% by 2018, implying annualized dividend growth of 18% and profit growth of 10% over the next five years.

Management has modest growth expectations from the Affordable Care Act this year. But it anticipates a greater impact over the long term as a projected 30 million Americans gain insurance, likely boosting prescription volumes and store traffic. CVS says its February decision to stop carrying cigarettes should depress annual sales by $2 billion, or less than 2%. CVS is expected to grow earnings per share 12% and sales 5% this year. The stock earns an Overall score of 91 and both sector-specific ranks exceed 90. CVS Caremark, yielding 1.5%, is a Buy and a Long-Term Buy.


Inflation provides a natural tailwind for Kroger's ($44; KR) annual sales, which have declined just once in the past 34 years. U.S. food prices surged 0.4% in February, the fastest one-month gain since September 2011.

In the past, Kroger has said it will sacrifice profit margins in order to maintain sales growth. The consensus projects continued margin expansion as well as solid growth, with per-share-profit growth of 13% in fiscal 2015 ending January on a 9% sales gain, followed by 10% higher profits and 4% higher sales in fiscal 2016.

In other news, attorneys general from 28 states and territories are urging Kroger and other large pharmacy retailers to follow the lead of CVS by halting the sale of tobacco products. So far, many retailers seem disinclined to move away from tobacco products, with Kroger saying adult customers have the right to make their own decisions, according to The New York Times. Kroger, with 2,640 stores in 34 states and Washington, D.C., is a Focus List Buy and a Long-Term Buy.


Recent results for Quanta Services ($36; PWR), a specialty contractor for pipelines and utilities, have been energized by the U.S. shale-drilling industry. Producers require new pipelines and other infrastructure to transport fuel from shale formations as utilities convert their facilities to burn natural gas instead of coal. Quanta grew sales at an annualized rate of 18% over the past three years, while cash from operations grew at a 23% annual clip, reaching a record $447 million in 2013. Returns on assets, equity, and investment stand at their highest levels in more than 12 years. Quanta's operating profit margin, at its highest level since 2009, seems poised to expand further. Quanta enters 2014 with an $8.73 billion backlog, up 25% from the end of 2013, that tilts toward projects with fatter profit margins. Management is also hunting for acquisitions of $50 million to $100 million in a bid to boost economies of scale.

After years of underinvestment in North America's electric grid, utilities are scrambling to upgrade their aging facilities. In addition, Quanta eyes growth opportunities from offshore U.S. projects and in Australia. The consensus estimate targets 17% higher per-share profits in 2014 on 16% revenue growth. Although the stock has rallied 15% this year, it still earns a Value score of 61. Quanta is a Buy and a Long-Term Buy.

MODELS OF CONSISTENCY
The 10 recommended stocks listed below have delivered five-year annualized growth for per-share profits, sales, and operating cash flow. In many cases, they have generated double-digit growth for multiple years. All 10 have also improved operating profit margins or return on equity — or both — over the past five years.
-- Annualized 5-Year Growth --
No. Of Years In Past 5 When
Annual Growth Exceeded 10%
5-Year Change
(Percentage Points)
------- Quadrix Scores -------
Company (Price; Ticker)
Earnings
Per
Share
(%)
Sales
(%)
Operating
Cash Flow
(%)
Earnings
Per
Share
Sales
Operating
Cash Flow
Oper.
Profit
Margin
(%)
Return
On Equity
(%)
Quality
Value
Overall
Apple ($545; AAPL)
49
39
41
4
4
3
12.0
7.0
99
94
93
Comcast ($50; CMCSa)
24
14
7
4
2
1
(5.6)
7.1
85
73
78
CVS Caremark
($75; CVS)
11
8
8
3
3
3
(0.6)
2.4
82
63
91
Foot Locker ($46; FL)
50
4
2
3
1
2
8.3
14.5
90
83
99
Kroger ($44; KR)
9
5
3
2
0
2
(0.7)
4.0
80
81
91
Magna International
($95; MGA)
85
8
19
2
3
3
2.0
15.3
91
86
99
Qualcomm ($79; QCOM)
16
17
20
4
3
4
(2.0)
1.4
95
73
96
Quanta Services
($36; PWR)
16
12
13
2
4
2
(0.1)
3.2
83
61
96
Skyworks Solutions
($38; SWKS)
16
16
24
3
4
3
8.9
1.5
96
64
99
Union Pacific
($187; UNP)
16
4
11
4
2
3
11.6
5.5
91
56
93
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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