Three Quadrix strategies

11/17/2008


Here at the Forecasts, we talk a lot about the Quadrix® stock-rating system because it works.

We use the system internally to select recommendations, but we realize that many of you also like to look at Quadrix data. The Quadrix Overall score considers more than 100 statistics and assigns percentile ranks to more than 4,000 U.S.-traded stocks based on those statistics.

Our strategy for tapping the power of Quadrix is simple: We use the quantitative system to select a basket of attractive stocks — generally those scoring 80 or higher Overall — then analyze companies individually to unearth our top picks. Those selections make up our Focus List, Buy List, and Long-Term Buy List. We advise most readers to select their favorite list and purchase equal-dollar positions in the stocks on the list.

Of course, we realize that many of you prefer to research stocks in your own way. But even investors who like to do their own legwork can benefit from the Quadrix system.

In the following paragraphs, we consider how Quadrix can help you with three appealing investment strategies:

Best of the best
While a diversified portfolio of 20 to 40 quality stocks represents the best option for most equity investors, some people prefer a tight focus on their best ideas, ruthlessly eliminating all companies except those with the strongest fundamentals. Our 13-stock Focus List uses that approach.

Quadrix can help you find those top-scoring stocks, as shown in the chart below. We divided the S&P 1500 Index into 33 baskets of stocks, each containing roughly 3% of the index, or 45 stocks. Our research has shown that even among high-scoring stocks, the very top scorers tend to outperform those with slightly lower scores.

In many cases, the top-scoring stocks are concentrated in just a few industries, and a strategy of buying only the very best could result in an unbalanced portfolio. But, as the chart indicates, the top basket averaged a 12-month return of 20.6% in a back-test of rolling periods since December 1994, with the second-highest basket averaging an 18.8% return. The average return for all the baskets was 13.3%. Reviewed below are two stocks from the top basket, which is limited to stocks with Overall scores of 95 and above.

Biogen Idec ($47; NASDAQ: BIIB) produces biotechnology drugs that treat non-Hodgkin’s lymphoma and multiple sclerosis. Per-share profits jumped 69% and operating cash flow surged 71% in the September quarter. Wall Street expects per-share-profit growth of 9% in 2009 and 7% in 2010, but good news on Biogen’s most-promising drug could render those targets conservative.

Roughly 38,000 patients use Tysabri for multiple sclerosis, up more than 80% from 2007 levels. During the summer, two patients suffered fatal side effects, sparking a warning on the label and a sell-off of Biogen shares. The stock is down 36% from July highs. However, recent data suggest the side effects occur roughly once for every 6,000 patients, well below the one-in-1,000 frequency listed on the drug’s label. Since the side-effect data was released in late October, Biogen shares have risen 16%.

Biogen’s solid balance sheet provides flexibility for spending on research or acquisitions. The company has a history of investing in itself, with expenditures on research and development accounting for nearly 32% of sales since 2004. At 12 times estimated 2009 earnings, Biogen shares are the cheapest of the six largest U.S. biotech stocks. Biogen is being initiated as a Focus List Buy and a Long-Term Buy.


Chevron ($74; NYSE: CVX) has enough cash to fund investment and expansion at a time when other companies are pulling back. At the end of September, Chevron had nearly $16 billion in liquidity, including $10.98 billion in cash and marketable securities ($3 billion net of debt) and an unused $5 billion revolving credit facility. Operating cash flow grew 56% to $10.85 billion in the September quarter.

An impressive project backlog should help Chevron boost production by at least 3% in each of the next two years. Six major projects are slated for launch in the next 18 months, including two — in Indonesia and the Gulf of Mexico — expected to start pumping in November. The company bought back $2 billion in shares in the September quarter and expects to repurchase a similar amount this quarter. Chevron, down 30% from its May high and trading at just eight times expected 2009 earnings, is a Buy and a Long-Term Buy.

Value focus
The Overall score is determined by six category scores, including a Value score that considers various valuation metrics. Because the Overall score considers many factors beyond valuation, it represents our best option for selecting stocks strong in many areas. But value investors may want to give the Value score extra weight.

As the table below illustrates, S&P 1500 stocks that score in the top quintile as measured by the sum of the Overall and Value score underperform the top scorers as measured by Overall score. But in some sectors — such as industrials, health care, and technology — the Overall/Value combination has worked very well in back-tests. One stock that earns solid scores in both Overall and Value is discussed below.

Cooper Industries ($27; NYSE: CBE) represents an impressive value from a number of angles. Down 51% from its 52-week high, the shares trade at eight times expected earnings — below the industry average of nine. At 5.3 times operating cash flow and 0.7 times sales, Cooper trades well below its three-, five-, and 10-year average valuations.

Given the company’s lean cost structure and strong balance sheet, Cooper seems well-prepared for an economic downturn. Job cuts already made should produce $50 million in annual savings starting in 2009, and additional cost cuts are in store. Cooper is also streamlining its supply chain. Inventory turnover picked up in the September quarter, and continued improvement should boost cash flow in 2009. The company took advantage of its low share price this year, repurchasing 11.1 million shares as of the end of October. In the 12 months ended September, the share count fell nearly 7%. Cooper is a Buy and a Long-Term Buy.

VALUE FOCUS
The table below shows average 12-month returns for the top one-fifth of stocks in each sector within the S&P 1500 as measured by Overall score, Value score, and a combination of both scores. Data is derived from a back-test of returns since December 1994.
—————— Average 12-Month Return ——————
All
Stocks
(%)
Top
Overall
Scorers
(%)
Top
Value
Scorers
(%)
Top
Overall/
Value
Scorers
(%)
Consumer Discretionary
22.9
25.2
26.0
24.7
Consumer Staples
10.1
14.9
16.0
16.9
Energy
13.5
13.4
15.8
15.5
Financials
9.5
15.4
10.8
15.1
Health Care
13.6
13.0
17.6
17.5
Industrials
16.3
16.3
18.0
18.8
Information Technology
16.0
18.5
19.5
20.3
Materials
15.6
20.7
18.3
15.9
Telecom Services
10.3
8.7
15.0
10.6
Utilities
13.9
15.0
16.7
15.2
S&P 1500 Index
13.3
17.1
15.7
16.2

Top industries
Our Group Studies Report, available in the Quadrix Tools section of the Subscriber Area at www.DowTheory.com, provides Quadrix data for 152 industry groups. Historically, industry groups with high average Overall scores have outperformed, and the Group Studies data can help you quickly identify those groups. The table below shows the average Quadrix scores for stocks in the 10 highest-scoring groups. One stock from the aerospace/defense group is reviewed below.

In the September quarter, General Dynamics’ ($59; NYSE: GD) overall backlog grew nearly 11% to $60 billion, of which 82% is already funded. Only the marine-systems unit saw backlog decline, though General Dynamics expects orders for its Virginia-class submarines to pick up soon. The company also anticipates that the new Congress will increase the number of ships in the Navy, which should support higher sales at the shipbuilding unit.

Business flight activity is down 9% for the year. As corporate profits slow, demand for General Dynamics’ Gulfstream jets could falter. But for the time being, General Dynamics will chew through the segment’s record backlog, which the company considers solid even given the distress in the financial markets. General Dynamics is a Buy and a Long-Term Buy.

TOP INDUSTRIES
————— Average Quadrix Score for Industry —————
Industry (No. of Stocks)
Momen-
tum
Value
Quality
Fin'l
Str.
Earns.
Ests.
Perfor-
mance
Overall
Integrated Oil & Gas (7)
88
85
90
79
20
56
95
Oil & Gas Drilling (11)
70
86
92
91
40
35
94
Steel (12)
67
93
88
64
20
21
85
Oil & Gas Equip. &
Svcs. (27)
64
81
85
77
43
30
84
Oil & Gas
Exploration (26)
74
70
84
77
18
41
82
Aerospace/
Defense (24)
65
68
78
62
58
52
78
Construction/
Engineering (10)
78
75
67
56
61
39
77
Managed Care (13)
58
84
70
59
50
49
77
Construction/Farm
Equip. (17)
61
78
77
58
42
35
76
Internet Retail (9)
59
58
84
80
44
44
75
Notes: Quadrix scores are percentile ranks, with 100 the best. Groups with fewer than seven companies are excluded.

 

SELECTIONS FROM THREE STRATEGIES
Below are listed 15 recommended stocks, five selected by each of three Quadrix screens. The “best of the best” screen considers only stocks in the top 3% of the S&P 1500 Index as measured by Quadrix Overall score. The “value focus” screen considers stocks that score well in both Overall and Value. And the “top industries” screen lists stocks in some of the industries with the highest average Overall scores.
Quadrix
—— Scores ——
Company (Price; Ticker)
Value
Overall
Div.
Yield
(%)
P/E on
Next-Yr.
Est.
Industry
Best of the best
Accenture
($30; ACN)
64
96
1.7
9
Technology
Consulting
Biogen Idec
($47; BIIB)
65
97
0.0
12
Biotechnology
Chevron
($74; CVX)
81
98
3.5
8
Integrated
Oil & Gas
National Oilwell
Varco ($26; NOV)
93
98
0.0
5
Oil & Gas
Equip. & Svcs.
Western Digital
($14; WDC)
97
98
0.0
5
Computer Storage
Value focus
Cooper Industries
($27; CBE)
84
87
3.7
8
Electrical
Equipment
Energen
($29; EGN)
84
85
1.7
7
Gas Utilities
Harris ($35; HRS)
75
96
2.3
8
Telecom
Equipment
NII Holdings
($18; NIHD)
95
88
0.0
6
Wireless Telecom
Services
Oceaneering Int’l
($27; OII)
87
94
0.0
7
Oil & Gas
Equip. & Svcs.
Top industries
Exxon Mobil
($73; XOM)
71
93
2.2
10
Integrated
Oil & Gas
General Dynamics
($59; GD)
70
92
2.4
9
Aerospace &
Defense
Manitowoc
($8; MTW)
99
82
1.0
3
Construction
& Farm Equip.
Schlumberger
($49; SLB)
66
87
1.7
10
Oil & Gas
Equip. & Svcs.
Transocean
($75; RIG)
84
97
0.0
5
Oil & Gas
Drilling
Notes: Quadrix scores are percentile ranks, with 100 the best.

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