Even On Autopilot, Quadrix Works

8/25/2014


Just set it and forget it. Whether roasting a chicken in those rotisserie ovens advertised on infomercials or enrolling in automatic payroll deductions for a 401(k), the ease promised by that tagline is highly alluring. No need for constant monitoring, no need for occasional tweaks.

While we do not suggest readers ignore our weekly advice, there is some evidence that putting a Quadrix-based stock portfolio on cruise control can be an effective strategy.

Most of our research involves using 12-month holding periods. This time we wanted to see how an investor would fare buying the top one-fifth of stocks in the S&P 1500 by Overall score and holding that portfolio for up to five years. Such analysis represents more than just curiosity — our Long-Term Buy List contains stocks we believe offer superior total-return potential over the next 24 to 48 months.

On an absolute basis, the one-year holding period delivered the highest average, median and geometric mean returns since 1994, as shown below. The geometric mean calculates a compound growth rate, helping to neutralize the variability of individual observations.

OVERALL SCORE EFFECTIVE OVER TIME
The effectiveness of the Quadrix Overall score stands the test of time. The top one-fifth of S&P 1500 stocks outperformed the average stock by an average of 2.3% in the 224 rolling 12-month periods since 1994. Over two-year holding periods, the top one-fifth of stocks outperformed by an annualized 2.2%, with that figure dipping to 1.3% for a five-year investment horizon.
---- Top One-Fifth Of S&P 1500 Stocks Versus Average Stock ----
1 Year
2 Years
3 Years
4 Years
5 Years
Annualized average return (%)
2.3
2.2
1.9
1.8
1.3
Annual. standard deviation (%)
5.1
2.9
2.6
2.9
2.6
Return/risk ratio
0.46
0.74
0.76
0.63
0.50
           
Annualized median return (%)
2.1
1.9
1.1
1.4
1.3
Geometric mean return (%)
2.2
2.1
1.9
1.8
1.2
           
Number of rolling periods
224
212
199
188
175
Winning percentage (%)
67
75
73
69
61

While the annualized outperformance of top scorers for two- and three-year periods lagged the average for one-year periods, returns looked more attractive relative to the volatility of that outperformance. We calculate a return/risk ratio by dividing average outperformance by standard deviation, a measure of how tightly relative returns are dispersed around the average. Top Overall scorers generated return/risk ratios of at least 0.74 for two- and three-year periods, versus 0.46 for one-year periods. Four- and five-year holding periods averaged lower annualized returns than shorter periods but still managed better return/risk ratios than one-year periods.

QUADRIX CATEGORY SCORES
Among S&P 1500 stocks since 1994, the Quadrix Overall score and Value score have shown solid predictive power over various holding periods up to five years. In contrast, Momentum, Quality, and Earnings Estimates scores have been a mixed bag, while Financial Strength and Performance scores have been ineffective.
-- Top One-Fifth Of S&P 1500 Stocks Versus Average Stock --
1 Year
(%)
2 Years
(%)
3 Years
(%)
4 Years
(%)
5 Years
(%)
Quadrix Overall score
Average annual. outperformance
2.3
2.2
1.9
1.8
1.3
Annualized standard deviation
5.1
2.9
2.6
2.9
2.6
Winning percentage
67.0
75.0
73.0
69.0
61.0
Quadrix Momentum score
Average annual. outperformance
0.4
(0.1)
0.0
0.2
0.2
Annualized standard deviation
6.4
4.0
3.1
2.9
2.4
Winning percentage
56.0
51.0
49.0
52.0
53.0
Quadrix Value score
Average annual. outperformance
2.9
1.9
1.3
1.3
1.1
Annualized standard deviation
10.4
5.7
4.1
3.8
3.5
Winning percentage
59.0
58.0
54.0
63.0
63.0
Quadrix Quality score
Average annual. outperformance
0.3
0.0
0.2
0.0
(0.6)
Annualized standard deviation
6.5
4.6
3.5
3.5
2.9
Winning percentage
50.0
49.0
56.0
55.0
39.0
Quadrix Financial Strength score
Average annual. outperformance
(0.8)
(0.4)
(0.2)
(0.2)
(0.3)
Annualized standard deviation
6.8
4.4
3.2
3.0
2.6
Winning percentage
40.0
39.0
43.0
54.0
53.0
Quadrix Earnings Estimates score *
Average annual. outperformance
0.0
0.0
0.3
0.1
(0.1)
Annualized standard deviation
7.0
3.7
2.5
2.0
1.9
Winning percentage
60.0
59.0
57.0
56.0
61.0
Quadrix Performance score
Average annual. outperformance
(0.2)
(1.0)
(0.9)
(0.9)
(1.1)
Annualized standard deviation
11.4
6.2
4.7
3.9
3.8
Winning percentage
54.0
54.0
48.0
52.0
49.0
* We have data for the Earnings Estimates score back to 2004; all the rest go back to 1994.

Not only did top scorers provide better risk-adjusted outperformance over long holding periods, they were also more likely to outperform. Holding periods from two to four years boasted higher winning percentages than one-year periods, meaning top scorers topped the return of the average stock more often.

TOP FACTORS IN QUADRIX

Value factors have dominated Quadrix over the years. To measure each factor's effectiveness, we looked at the average outperformance of S&P 1500 Index stocks that ranked among the top one-fifth, evaluating both average and median returns for five distinct holding periods ranging from one to five years.

Importantly, the five factors below consistently ranked among the top 20 factors in our stock-rating system. For example, S&P 1500 stocks that scored above 80 for enterprise value/EBITDA outperformed by an annualized average of 2.7% annualized and a median of 2.3% over the following two-year period.

-------------------------------------------- Top One-Fifth Of S&P 1500 Stocks Versus Average Stock --------------------------------------------
--------------- Average Outperformance % (Rank) ---------------
--------------- Average Outperformance % (Rank) ---------------
--------------------- Annualized ---------------------
--------------------- Annualized ---------------------
1 Year
2 Years
3 Years
4 Years
5 Years
1 Year
2 Years
3 Years
4 Years
5 Years
Enterprise value/EBITDA
3.8
(1)
2.7
(1)
1.7
(4)
1.3
(9)
1.0
(10)
3.3
(1)
2.3
(2)
1.0
(8)
0.6
(15)
0.3
(15)
Price/book
3.6
(2)
1.8
(9)
0.8
(12)
0.8
(16)
1.0
(9)
1.6
(7)
1.3
(6)
0.3
(23)
0.1
(34)
0.3
(18)
Price/cash flow
2.7
(9)
2.0
(4)
1.7
(5)
1.7
(3)
1.4
(5)
2.0
(4)
1.5
(5)
1.0
(9)
0.7
(14)
0.9
(6)
Price/free cash flow
3.3
(5)
2.5
(2)
1.9
(3)
1.5
(8)
1.3
(6)
2.1
(3)
2.5
(1)
1.3
(5)
1.0
(10)
1.0
(4)
Price/sales
3.5
(4)
1.8
(7)
1.4
(8)
1.5
(7)
1.5
(4)
2.9
(2)
2.1
(3)
1.5
(3)
0.6
(17)
0.9
(5)

In the table below we present 15 stocks that score above 75 for Value, above 85 for Overall, and also score well for some of the most effective individual Quadrix factors. Three intriguing options are discussed below.

Aetna ($78; AET) consistently scores well in Quadrix, its Overall rank topping 80 in 21 of the past 24 months. It has earned a Value score of 80 or higher in 11 consecutive months and scores in the top half of our research universe for the five Quadrix factors that have proved highly effective across multiple time horizons, shown in the table below. The stock also looks cheap based on its P/E ratio of 12, which earns a factor rank of 84 and is 24% below the median for S&P 1500 managed-care stocks.

Aetna's stock has rallied 25% in the past year, ahead of the 22% average for its peer group and the S&P 1500's 20% gain. But in recent weeks, renewed fears of rising utilization trends have pressured the shares. Medical costs are finally beginning to creep higher, as they eventually do during expansionary periods. However, the uptick could prove more gradual than in prior periods, considering higher deductibles and new efforts to constrain costs as the government takes a greater interest in the industry. Aetna, already a Long-Term Buy, is being added to the Buy List.


Southwest Airlines ($31; LUV) earns the maximum Overall score of 100, bolstered by all six category scores ranking in the top 30% of our research universe. Both sector-specific scores are 99. The airline enjoys steadily improving returns on assets, equity, and investment. Free cash flow jumped 63% to $1.42 billion in the 12 months ended June. Sales have risen in 17 of the past 18 quarters, including 8% growth in the June quarter.

Southwest jumped off to a strong start in the current quarter, with traffic up 6.6% in July. Rising analyst estimates anticipate 36% higher per-share profits in the second half of the year, compared to average estimated growth of 23% for S&P 1500 airline stocks

The shares have held up well in the past month, producing an 11% total return while Southwest's peers averaged 3%. As the largest domestic carrier, Southwest enjoys strong U.S. demand trends, while avoiding the increased competition on transatlantic flights. In July, Southwest said it plans to resume a "measured" expansion strategy that calls for seat-capacity growth of 2% to 3% next year. Southwest Airlines is rated A (above average).


UGI's ($51; UGI) Value score of 78 reflects above-average ranks for 58% of factors within the category. The stock's price/sales, price/cash flow, and enterprise (enterprise value/earnings before interest, taxes, depreciation, and amortization) ratios score above 80 in Quadrix. UGI also trades at least 19% below the median for S&P 1500 natural-gas utilities for all three of these ratios. The stock's trailing P/E of 17 is 9% below its peer-group median.

Do not dismiss UGI as solely a value play. It also earns outstanding scores for Momentum (90) and Earnings Estimates (86). This combination is in short supply — fewer than 50 S&P 1500 stocks score above 75 for Value, Momentum, and Earnings Estimates. Per-share profits grew more than 25% in the first two quarters of 2014, building on 36% growth in 2013. Sales have risen at least 5% in 10 straight quarters, a trend analysts expect to continue in the seasonally light September quarter.

UGI is more than a gas utility. It generates most of its revenue from distributing propane, both in the U.S. and overseas. Last month, the company announced a three-for-two stock split and raised its dividend 10%. UGI, yielding 2.5%, is a Buy and a Long-Term Buy.

TOP STOCKS ON FIVE QUADRIX FACTORS
We screened for high-potential stocks scoring above 75 for Quadrix Value and above 85 for Overall. In addition, we focused on stocks with above-average scores in the most effective individual Quadrix factors over holding periods ranging from one to five years. The A-rated stocks listed below should appeal to buy-and-hold investors; those recommended for immediate purchase are listed in bold.
Quadrix
----- Scores -----
Ent. Value/
----- EBITDA -----
Price/
------ Book ------
Price/Cash
------ Flow ------
Price/Free
--- Cash Flow ---
Price/
------ Sales ------
Company (Price; Ticker)
Value
Overall
Ratio
Rank
Ratio
Rank
Ratio
Rank
Ratio
Rank
Ratio
Rank
Aetna ($79; AET)
88
95
6.8
82
1.9
55
10.0
69
9.5
88
0.5
89
Cigna ($94; CI)
85
95
6.6
83
2.3
46
9.3
74
13.5
80
0.7
82
Hewlett-Packard
($35; HPQ)
93
90
5.8
88
2.4
43
6.6
88
10.2
87
0.6
86
IBM ($190; IBM)
91
93
9.3
61
10.9
6
8.7
77
21.5
57
1.9
51
Macy's ($59; M)
89
95

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