Quadrix Lights Our Path

9/5/2016


It might surprise some subscribers to learn we play no favorites with any industry or sector when it comes to selecting new Buys. We don't use mandates to ensure that a certain number of stocks hail from specific pockets of the market. Instead, Quadrix helps dictate where we focus our energy.

While fishing for new candidates to add to our buy lists, we seek stocks with high Overall scores, preferably over 90. Although we do not target specific industries, we get more nibbles in pools stocked with a large school of high Quadrix scorers.

Sure enough, we recommend at least one stock in each of the top five industries based on average Overall score. These five industries, shown at the top of the table below, account for four of the 13 stocks on the Focus List and five of our 24 Buy-rated stocks.

TOP S&P 1500 INDUSTRIES BY OVERALL SCORE
Although airline stocks have underperformed this year, they earn an average Quadrix Overall score of 91, highest among the 103 industries in the S&P 1500 Index with at least five stocks. All numbers are averages.
Avg. Year-
To-Date
Total
Return
(%)
------------------------- Quadrix Scores -------------------------
S&P 1500 Industry
(Number Of Stocks)
Momen-
tum
Value
Quality
Earnings
Estimates
Overall
Airlines (9)
(5)
64
94
94
43
91
Homebuilding (15)
13
82
76
91
49
90
Auto parts & equip. (13)
11
70
78
81
71
87
Home furnishings (5)
17
84
63
87
76
87
Building products (15)
24
82
48
90
66
82
Life & health insurance (11)
7
53
93
59
56
80
Paper products (6)
12
52
81
65
57
78
Reinsurance (6)
9
55
81
68
47
76
Automotive retail (12)
(5)
64
69
84
51
75
Regional banks (80)
10
62
69
64
54
75
S&P 1500 average
13
51
55
63
50
59
Note: Quadrix scores are percentile ranks, with 100 the best.

As we explain on below, high Quadrix scores and robust operating momentum have not prevented airline stocks from delivering disappointing returns. Also below, we look at three industries exposed to the improving residential and commercial construction market: homebuilding, home furnishings, and building products. These construction-focused industries have fared well, returning more than 10% including dividends in 2016.


Airlines priced for disaster

Airline profits have soared in the past 12 months, as the improving economy stoked demand for air travel and unusually low fuel prices padded profits. The nine airline stocks in the S&P 1500 Index have averaged 49% higher earnings per share on 2% revenue growth for the 12 months ended June. But, judging from the industry's current valuation, investors have little faith the momentum will last. 

Airline stocks have rarely been so cheap. The average S&P 1500 airline stock currently trades at 7.9 times trailing earnings. In the past 240 month-end periods, spanning 20 years, the airline industry has seen a lower average P/E ratio just twice — in May and June 2009, when it traded at 6.6 times trailing earnings.

The airline industry also looks unusually cheap relative to the broad index. The industry's average trailing P/E ratio of 7.9 is just 34% of S&P 1500 index average of 23.0. Said another way, airline stocks trade 66% below the average S&P 1500 stock — the steepest discount in 20 years. The industry has averaged an 18% discount to the index over that period.

There is some justification for airline stocks to trade at a discount to other stocks. High fixed costs limit their pricing power, and airline executives have historically shown little restraint in expanding capacity, putting additional pressure on airfares. As a result, the industry has experienced more than its share of booms and busts. 

However, consolidation has reduced the number of industry participants and could make airlines act more rationally on pricing and capacity going forward. Low interest rates have allowed companies to invest in lighter, more efficient jetliners that should help keep fuel costs low, even as oil prices begin to rise. U.S. oil prices currently hover around $50 a barrel, near where they traded this time last year.

Forward P/E ratios also indicate distrust of analyst estimates. Airline stocks trade at 8.4 times estimated 2016 profits, lower than 94% of months in the past 10 years. That forward P/E ratio lingers 60% below the S&P 1500 average forward P/E ratio of 20.9 — just 2% of months in the past decade have witnessed a bigger discount.

Airfares are down 6% this year, according to industry group Airlines For America. However, airlines have succeeded in raising prices eight times out of 15 attempts this year. The industry's success rate was about 18% from 2013 to 2015. While airlines have cut more than raised this year, their ability to make price hikes stick bodes well for what will become necessary as fuel prices bounce back.

Our two recommend airline stocks, Alaska Air Group ($68; ALK) and Southwest Airlines ($37; LUV), have lost more than 14% this year, worse than the industry average loss of 6%. Both stocks trade at nine times trailing earnings and 10 times estimated 2016 earnings. Their premiums to the industry seem warranted given their high exposure to the U.S. market, which is proving more resilient than Europe and Latin America.

Southwest noted soft pricing in the June quarter, though it was among the U.S. airlines to raise fares in the past month. For Alaska Air, capacity growth in its key markets appears to be easing, which could boost its efficiency metrics in the second half of the year. Alaska Air is a Buy and a Long-Term Buy. Southwest Airlines is a Focus List Buy and a Long-Term Buy.


More constructive on construction

The housing and commercial-construction markets have been among the brightest spots in the U.S. economy this year. Improving fundamentals, strong share-price action, and decent valuations in this space are also being reflected in Quadrix. The homebuilding, home-furnishings, and building-products industries earn average Overall scores that rank in the top five among all industries.

We recommend one stock from each industry:

• D.R. Horton ($32; DHI), the largest U.S. homebuilder, currently targets the underserved market of first-time homeowners.

• Mohawk Industries ($213; MHK), the largest U.S. maker of tile, carpeting, hardwood, and laminate flooring.

• Owens Corning ($55; OC), a manufacturer of insulation, roofing, and fiberglass composites used in residential and commercial buildings.

July sales of new homes surged 12% from June to a seasonally adjusted annual rate of 654,000 units, well ahead of economist expectations and the highest level since October 2007. Some of the strongest growth last month occurred in the South, D.R. Horton's largest geographic market, accounting for 54% of revenue in the nine months ended June. Nationwide, new-home sales also rose 12% for the first seven months of 2016 compared to the same period last year.

Initial reports of new-home sales data have historically been volatile and not always reliable. New homes also represent less than 10% of all U.S. home purchases, meaning they present an incomplete picture of the overall housing market. Although July sales of existing homes slipped 3% from June, the decline was partly attributed to tight inventories. The supply of existing homes on the market has fallen in each of the past 14 months.

Confidence among homebuilders is rising, and single-family housing starts rose in July to a five-month high. Yet new-home construction remains 30% below its historical average, according to The Wall Street Journal, signaling what may be a long runway for future growth. The inventory of unpurchased new homes has fallen to its lowest level in three years.

Historically low mortgage rates have helped fuel home sales. In late August, Janet Yellen, head of the Federal Reserve, said, "The case for an increase in the federal funds rate has strengthened in recent months." Futures traders see a 54% chance of the Fed raising rates by December, compared to a 27% possibility in September. But rate hikes are still expected to happen gradually, and interest rates themselves should remain unusually low.

Shares of D.R. Horton, Mohawk, and Owens trade at discounts to their industry averages relative to both trailing earnings and estimated current-year earnings. Both D.R. Horton and Mohawk are projected to generate double-digit profit growth over the 12 months ending June. Although the consensus projects 1% lower earnings per share for Owens Corning in the coming year, analyst estimates have risen sharply in the past 30 days. The company has topped the consensus profit estimate in eight straight quarters.

All three stocks offer upside of at least 18% in the coming year if they meet consensus profit estimates and their trailing P/E ratios revert to industry norms. D.R. Horton, Mohawk, and Owens are rated Focus List Buy and Long-Term Buy.

BUILDING AN ATTRACTIVE PORTFOLIO
Three S&P 1500 industries leveraged to the residential and commercial construction markets — homebuilding, home furnishings, and building products — look attractive in Quadrix based on recent operating momentum and valuations. We recommend one stock from each industry. Industry and index numbers are averages.
Year-
To-Date
Total
Return
(%)
----- P/E Ratio -----
12-Month
--- Change ---
Est. EPS
Change,
Next 12
Months
(%)
-------- Quadrix Scores --------
Company (Price; Ticker)
Trailing
Forward
EPS
(%)
Sales
(%)
Overall
12-
Factor
Sector
Reranked
Overall
S&P 1500
Industry
D.R. Horton ($32; DHI)
1
14
12
23
14
14
94
92
84
Homebuilding
Mohawk ($213; MHK)
12
18
16
30
10
14
96
57
93
Home furnishings
Owens Corning ($55; OC)
18
16
16
52
5
(1)
98
96
98
Building products
S&P 1500 industry (number of stocks)
Homebuilding (15)
13
16
13
30
22
22
90
71
80
Home furnishings (5)
17
19
17
24
4
13
87
67
80
Building products (15)
24
26
22
31
10
18
82
62
69
S&P 1500 Index
13
22
21
3
2
7
59
50
50
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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