Living The High (Quadrix) Life
Longtime readers might remember the following three basic facts about our Quadrix system:
1) Stocks with top Value scores tend to deliver higher total returns than those that score well in any other category, and even the Overall score.
2) Portfolios limited to high Value scorers are substantially more volatile than top Overall scorers. In most cases, portfolios driven by the Overall score provide a better ratio of return per unit of risk.
3) Stocks with extremely high Value or Overall scores tend to outperform those with merely high scores.
Most of our back-testing revolves around quintiles, or fifths, considering portfolios that contain the top 20% of an index as measured by a particular Quadrix score. This week we focus on the very top scorers to show whether investors taking advantage of fact 3 would run afoul of fact 2. We found the difference in risk between Value- and Overall-oriented strategies is more pronounced for the top 3% of scorers in the S&P 1500 Index than for the top 20%. See the charts below for details.
The smaller portfolios created using the top 3% strategy explain some of the risk/return phenomenon, but not all of it. Even with equal-numbered baskets, stocks earning extremely high (or low) scores tended to be more volatile than those toward the middle.
We found that for strategies involving the top 3% of the index, requiring high scores for both Overall and Value boosted both returns and return per unit of risk relative to requiring high scores for just one of the metrics. However, each time we loosened the strictures — top 6%, top 10%, top 20% — the benefit of using both scores eroded, with Value-driven strategies tending to provide higher returns, while Overall-driven strategies offer superior returns per unit of risk.
What do these numbers mean? Here are three takeaways:
1) Since 3% of the S&P 1500 Index is just 45 stocks, and individual company analysis frequently finds major flaws in even the highest-scoring stocks, strategies that consider just 3% are impractical. You need a larger pool to create a diversified portfolio of high-quality stocks.
2) The Overall score still provides the best blend of risk and return and should remain your first screen in the stock-selection process.
3) Stocks with low Value scores tend to deliver poor returns (see the charts below). Don't limit yourself only to super-high Value scorers — many of our best-performing stocks aren't deep values — but avoid stocks with Value scores below 30.
Lincoln National ($55; LNC) earns an Overall score of 99, highest among the 11 life & health insurance stocks in the S&P 1500, a group that averages a score of 79. The stock's Value score doesn't rank in the top 6%, but it's a more than respectable 87. At nine times estimated 2015 earnings, Lincoln trades 22% below the peer-group median. Even more striking is the price/earnings-to-growth (PEG) ratio, which divides current-year estimated per-share profits by estimated long-term profit growth. Lincoln has a PEG ratio of 0.9, versus 1.2 for its peers.
The stock earns a 99 in Earnings Estimates, reflecting its superior revision trends. The consensus projects per-share-profit growth of 6% for the December quarter and 7% for 2015, but the full-year target has been trending higher for the last three months. Profits have topped the consensus by at least 7% in each of the last two quarters, suggesting analysts are still underestimating Lincoln's capabilities. The stock, which yields 1.5%, is a Long-Term Buy.
Micron Technology ($32; MU) earned $0.97 per share in the November quarter, up 26% and $0.05 above the consensus. Revenue rose 13%, short of analyst expectations. Micron projected February-quarter revenue below the consensus, hurt by plans to reconfigure production lines, and shares fell on the news. However, the company sees continued solid demand for its memory products.
Micron earns the maximum possible Overall score of 100. Its Value score of 84, while not among the very best in our research universe, is tied for the top among S&P 1500 semiconductor stocks — and nearly twice the industry average of 43. At just 10 times trailing earnings, Micron trades 52% below the semiconductor industry median. Micron is a Buy and a Long-Term Buy.
Over the last 12 months, Packaging Corp. of America ($77; PKG) grew sales 81%, per-share profits 57%, and operating cash flow 30%, boosted by the acquisition of papermaker Boise. Such merger-driven growth won't continue, but analysts expect per-share profits to rise 13% on 5% sales growth this year.
The shares have returned 23% over the last three months, in part because of talk that part or all of the company might restructure as a master limited partnership (MLP). Despite their strong returns, PCA shares remain attractively valued at 15 times projected year-ahead earnings, 14% below the industry average. Any MLP speculation is just that — speculation — because the Internal Revenue Service has frozen all applications for the tax-protected structure while it reviews its own rules. Rival International Paper ($52; IP) said it plans to seek MLP status, though whether a paper company would qualify was uncertain even before the IRS moratorium.
PCA earns an Overall score of 99, well above the industry average of 72. Packaging Corp., which yields 2.1%, is a Buy and a Long-Term Buy.
Property & casualty insurer Travelers ($105; TRV) scores 98 Overall, squarely within the top 3%, and earns a 93 in Value, barely missing the top 6%. Because of the nature of its business, Travelers probably won't provide steady sales and profits — its results vary too much based on the weather, which can cause massive variants in the catastrophic claims the company must satisfy from quarter to quarter. However, in recent quarters the trend has been upward, with per-share profits up 35% in the 12 months ended September and operating cash flow up 22%.
At 10 times trailing earnings, Travelers trades at a 12% discount to its own three-year average and 29% below its peer-group median — this despite strong underwriting trends. Analysts expect per-share profits to fall 6% this year, a number that seems conservative even factoring in a rebound from this year's unusually low catastrophic claims. Travelers, yielding 2.1%, is a Buy and a Long-Term Buy.