Put Stocks Through Their Paces
To traverse an obstacle course quickly, a competitor needs strength, stamina, and the flexibility to cope with a variety of impediments. The military and law enforcement often use obstacle courses to identify weaknesses, showing recruits where they need to improve before going into the field.
Why not demand everything?
You may be wondering why we don't simply require top marks in every category. The reason is because if we set the bar too high, no stocks would clear it.
For example, of the nearly 5,000 stocks in our Quadrix universe, only 87 earn scores of above 60 in all six categories (Momentum, Value, Quality, Financial Strength, Earnings Estimates, and Performance), ranking them in the top 40%. Require scores above 70 (top 30%), and only 16 stocks make the grade, while just two earn scores above 80 (top 20%) in all six categories. No stocks earn above 90 (top 10%) across the board.
The point of an obstacle course is not to identify the very strongest companies in a particular area. Instead, think of the stock-analysis process like a decathlon.
The best decathletes would probably lose one-on-one competitions against the top pole vaulters or hurdlers or discus throwers. However, they should trounce the specialists in most of the other nine events because they're pretty good at everything.
It's too bad we cannot put stocks through their own obstacle course to weed out the slow and weak. Or can we?
In many ways, our stock-selection process resembles an obstacle course, with each hazard providing another chance for the strongest, fastest, and toughest to leave competitors behind. Today we take you through a five-step course to see which stocks are resilient enough to make it to the end.
Our analysis system doesn't always set up the same obstacles; each time we put stocks through the course, we'll alter the criteria. But today's exercise should give you a peek behind the stock-picking curtain.
Stage 1 — Quadrix
Veteran readers know that size and the QuadrixÂ® stock-rating system represent our initial screens. Of the more than 4,800 U.S.-traded stocks in our research universe, only 1,122 have market capitalizations above $4 billion, the typical minimum for Dow Theory Forecasts.
Of those 1,122 stocks, just 30% earn Overall scores of at least 80. A score above 80 is a firm rule for new recommendations, though we prefer scores well above 80 if possible. For this screen, we required Overall scores of at least 90.
Number of stocks left: 168.
Stage 2 — Growth
We always consider growth when exploring for new Buys. That doesn't mean we require double-digit gains in every statistic. Rather, we're looking to eliminate companies that have trouble generating the sales and profit growth typically required to support higher stock prices.
Today's screen required sales growth of 5% and per-share-profit growth of 10% over the last 12 months and annualized over the last three years. Those criteria may not sound too onerous on the surface, yet the screen knocked out more than half of the remaining competitors.
Number of stocks left: 77.
Stage 3 — Value
When we screen for value stocks, we like to see multiple indications of value — high Quadrix Value scores and valuation ratios below the average for their sector, industry, or historical norms. However, the obstacle course is not designed to find the very cheapest stocks.
Remember, we've already screened for high Quadrix scores and solid sales and profit growth, which leaves us with a high-quality batch of stocks to consider. Few such stocks will trade at extremely cheap prices. In addition, we still have two more steps after this one in our quest to identify well-rounded investment opportunities.
With the larger goal in mind, we screened for stocks with Quadrix Value scores above the average for our research universe and a price/earnings ratio below the universe average and the stock's own five-year historical norm.
Number of stocks left: 63.
Stage 4 — Share-price action
Just about every stock we analyze must complete the first three legs of this obstacle course, or something similar. The specifics might change, but the obstacles (Quadrix scores, growth, and value) remain the same whenever the Forecasts trolls for new buy ideas. By now, we've pared the list down to a manageable number of stocks that satisfy our core investment goals.
The last two stages of our course focus on specifics beyond growth and value. We could have considered dozens of criteria, such as profitability, yield, dividend growth, debt levels, cash flow, etc. Today we're limiting the screen to share-price action and earnings-estimate trends.
This stage of the obstacle course requires each stock to top the year-to-date and 12-month total returns of the average stock in our universe of nearly 4,900.
Number of stocks left: 44.
Stage 5 — Estimate trends
With only 44 stocks left in the race, we draw on estimate trends to see which ones survive the sprint to the finish. This obstacle is simple: The stocks' Quadrix Earnings Estimates scores must hurdle the average of 50, and their per-share-profit estimates for the current fiscal year and the next year must have risen at least 1% over the last 90 days.
Of course, simple doesn't always mean easy. This last obstacle tripped up 59% of the remaining competitors.
Number of stocks left: 18.
By setting up five obstacles, we eliminated more than 98% of the midcaps and large-caps that started the race.
The 18 stocks that navigated our obstacle course are listed in the table below. While none of the stocks are near the top in everything, the process of separating the weak from the strong in every category created a mix of companies that are well above average in most areas.
Some sectors run stronger than others
Sometimes readers see that our recommended lists overweight certain sectors relative to the broad market and assume we endorse the sector.
Don't make that mistake.
Sector weightings can change substantially as we screen stocks for various characteristics. For instance:
While technology stocks account for just 13% of the 1,122 U.S.-traded stocks with a market capitalization of more than $4 billion, they make up at least 15% of the stocks that completed each leg of our obstacle course and 28% of the elite group still standing after Stage 5. This doesn't mean we recommend investors purchase a lot of technology stocks, just that we find more individual stocks with appeal in the tech sector than we do in, say, the health-care sector.
Other sectors with an above-market survival rate on our obstacle course are industrials and consumer discretionary. In contrast, the percentage of consumer-staples, energy, health-care, and telecom stocks that cleared each hurdle lagged the percentage that started the race. Financials did OK for the first three stages but fell off during stages four and five.
Not surprisingly, our Buy List contains a higher percentage of consumer-discretionary, industrial, and technology stocks than the pool of large-caps and midcaps in our research universe, while underweighting financials, health care, and telecom. Readers should treat those recommendations as endorsements of individual stocks, rather than a blanket buy or sell call for a market sector.