Wave-Riders, Beware The Undertow

3/23/2015


Like surfers, investors are always searching for the next big wave. Although their approaches may differ, value investors and price-momentum investors are alike in one way — both try to swim in choppy waters.

The Forecasts often discusses the value approach, which involves buying in the belief that a wave will come. Today we consider investors who buy stocks already on their way up — and who believe they can get out before the wave breaks.

Price-momentum cycles can be as short as a few weeks, meaning investors risk racking up excessive trading fees by rushing in and out of stocks. At its worst, the strategy devolves into speculation, or the "greater-fool game," in which investors purchase overvalued stocks in the hope someone else will pay even more for them.

CHASING RETURNS DOESN'T WORK IN QUADRIX
Over the past decade, stocks scoring above 80 for Performance went on to underperform the average S&P 1500 stock by an average of 0.2% over the next month and by an average of 1.9% over the next 12 months. Among the six Quadrix categories, Performance ranks no better than fifth in effectiveness over the past one-, five-, and 10-year periods, and since the index's 1994 inception.
Overall
(%)
Momen-
tum
(%)
Value
(%)
Quality
(%)
Fin'l
Str.
(%)
Earns.
Ests.
(%)
Perfor-
mance
(%)
1-month average out(under)performance
Since Inception
0.4
0.2
0.5
0.1
0.0
0.0
(0.1)
Last 10 Years
0.0
(0.1)
0.3
0.0
(0.1)
0.0
(0.2)
Last 5 Years
0.1
0.1
0.2
0.0
(0.2)
0.1
(0.2)
Last 1 Year
0.3
0.2
0.0
0.2
(0.3)
0.4
(0.2)
12-month average out(under)performance
Since Inception
2.3
0.4
2.8
0.3
(0.9)
0.1
(0.2)
Last 10 Years
0.5
(0.2)
2.3
(0.3)
(2.0)
0.1
(1.9)
Last 5 Years
(0.1)
(0.7)
1.6
(0.8)
(3.8)
0.2
(0.9)
Last 1 Year
2.0
0.4
3.3
(0.8)
(2.9)
1.0
(1.5)

Our back-tests support what could be called the winner's curse. Since December 1994, the top quintile of stocks in the S&P 1500 Index based on three-month returns went on to underperform the average stock in the index in the next month and over the next 12 months.

Buying stocks based solely on the Quadrix Performance score hasn't worked well, either. The Performance score considers a stock's total return over seven time periods (anywhere from two months to five years, with the bulk of the weighting coming from periods of 12 months or less).

Performance has lagged since 2008 — but it used to work, especially in upward-trending markets (such as 1995 to 1999 and 2005 to 2006). These exceptionally strong periods were typically followed by dreadful results for Performance during downturns (2000 and 2008) and initial recoveries (2002 to 2003, 2009). Despite recent weakness, Performance has worked in 53% of 12-month periods since its December 1994 inception.

TOP INDUSTRIES
The following S&P 1500 industries have produced the highest average returns in 2015. Nearly one-third of our recommended stocks come from these 10 industries.
S&P 1500 Industry
(Number Of Companies)
Avg. YTD
Return
(%)
Pharmaceuticals (23)
19
Managed Health Care (10)
18
Life Sciences Tools & Svcs. (13)
15
Airlines (6)
15
Oil & Gas Refining & Mktg. (8)
15
Biotechnology (14)
15
Specialized Finance (8)
11
Application Software (31)
11
Human Resource Services (11)
10
Semiconductors (36)
10
Note: Industries with fewer than five companies excluded.

We give Performance a fairly small weighting in the Overall score but view it as a helpful signal that a stock is headed in the right direction, especially when it also earns high Momentum and Earnings Estimates scores.

Stock performance can reflect investor demand for companies with robust operational growth. The top 20% of S&P 1500 stocks based on year-to-date returns averaged stronger operating growth in the latest quarter than the index average. They are also projected to average 12-month profit growth of 12%, versus 6% for all stocks in the index. However, the group looks expensive.

Investors need not always pay a big markup for growth. In the table below we present 12 A-rated stocks that earn above-average ranks in Quadrix categories that gauge value and operating momentum, while also scoring above 80 for Performance. One of those stocks, Jones Lang LaSalle ($164; JLL), is reviewed on Analysts' Choice, with four more discussed below. Three of the four are from the top-performing industries listed above.

Aetna ($107; AET) shares have outpaced the S&P 1500 managed-care industry, returning 21% so far in 2015. Yet Aetna's stock remains unduly cheap. Aetna has the lowest P/E ratio in the industry based on trailing earnings (16 versus the industry median of 23).

The consensus projects Aetna's per-share earnings will rise 7% to $7.18 this year. Aetna has delivered seven straight quarters of double-digit revenue growth, a trend expected to continue in the March quarter. Gross profit margins steadily expanded over the past year, while operating cash flow surged 48%. Aetna is a Focus List Buy and a Long-Term Buy.


Alaska Air Group ($68; ALK) shows remarkable balance in Quadrix, scoring above 70 for Momentum, Value, and Performance — a trait shared by just 2% of S&P 1500 companies. Per-share profits jumped 55% last year on 8% revenue growth. Despite strong operating momentum, shares trade at just 11 times estimated 2015 earnings per share, which are projected to grow 48%.

The stock has produced total returns of 14% so far in 2015 and 50% over the past 12 months, both ranking in the top 12% of our research universe. The stock can be influenced by oil prices, as fuel represents about one-third of the company's operating expenses. Recently, that sensitivity has been a good thing, as U.S. oil prices fell to a 69-month low in March. Alaska Air is a Focus List Buy and a Long-Term Buy.


Apple's ($128; AAPL) 12-month return of 74% is surpassed by only about 3% of stocks in our research universe. Demand for Apple's products, both new and old, could help the stock advance further in the coming year. The iPhone outsold Samsung Electronics' smartphone offerings in the December quarter, according to research firm Gartner.

Apple Pay is now supported by 2,500 banks, up from 750 in late January, and has become popular with consumers as well. About 40% of iPhone 6 users have already made a purchase with Apple Pay. Apple is a Focus List Buy and a Long-Term Buy.


Nvidia's ($23; NVDA) expansion into automotive and data-center end markets lessens its exposure to the soft personal-computer market. Consider semiconductor bellwether Intel ($31; INTC), which slashed its quarterly guidance earlier this month because of sluggish PC demand. While Intel's shares plunged 5% on the news, Nvidia's stock held up relatively well, slipping less than 1%. Nvidia shares have produced a total return of 14% this year, outpacing the average return of 10% for S&P 1500 semiconductor stocks.

In the past three years, Nvidia has returned 111% of free cash flow to shareholders through dividends and stock buybacks. Yet the balance sheet contains net cash of nearly $6 per share, representing one-fourth of the stock price; capital returns to investors could rise in coming years. Nvidia is a Focus List Buy and a Long-Term Buy.

FORECASTS' HIGH FLYERS
We screened for stocks rated A (above average) that score in the top quintile for Quadrix Performance, supported by solid operating momentum and reasonable valuations. Stocks recommended for purchase are in bold.
---- Total Return ----
-- P/E Ratio --
Last-Quarter
-- Change --
Est. 12-
Month
EPS
Growth
(%)
--------- Quadrix Scores ---------
Company (Price; Ticker)
1
Mo.
(%)
YTD
(%)
12
Mos.
(%)
Trailing
12 Mos.
Est.,
Next
12
Mos.
EPS
(%)
Sales
(%)
Momen-
tum
Value
Perfor-
mance
Overall
S&P 1500
Industry
Aetna ($107; AET)
11
21
49
16
15
(18)
12
7
53
70
87
84
Managed care
Alaska Air
($68; ALK)
10
14
50
16
11
75
8
47
91
74
91
98
Airlines
Anthem
($157; ANTM)
12
26
68
18
16
76
6
11
86
68
90
89
Managed care
Apple ($128; AAPL)
1
17
74
17
15
48
30
18
94
69
88
99
Tech hardware
Boeing ($156; BA)
4
21
27
18
18
4
3
(1)
59
55
89
82
Aerosp. & defense
Cigna ($127; CI)
10
24
64
17
15
23
10
12
65
63
91
86
Managed care
General Motors
($39; GM)
4
11
15
14
8
76
(2)
65
60
83
84
81
Auto manufact.
Jones Lang
($164; JLL)
2
10
38
19
18
29
16
4
95
63
81
97
Real estate svcs.
Nvidia ($23; NVDA)
3
14
31
16
15
35
9
6
96
57
90
97
Semiconductors
Southwest Air.
($46; LUV)
8
8
92
23
13
10
5
74
78
61
85
94
Airlines
Target ($81; TGT)
6
8
40
23
18
74
1
29
90
62
84
87
Gen. merchandise
Valero Energy
($62; VLO)
5
26
17
9
10
24
(19)
(9)
68
94
83
99
Oil & gas refining
S&P 1500 average
1
3
11
22
21
6
7
6
52
56
55
59
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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