Chiseling Our Way To Great Stocks

7/17/2017


The artist Michelangelo has been credited with saying, "every block of stone has a statue inside it, and it is the task of the sculptor to discover it." For investors, we can tweak this quote to: "Every index contains a handful of great stocks, and it's up to the stock picker to identify them."

Using the S&P 1500 Index as our block of stone, we took the following six steps to carve out a small group of especially attractive stocks.

• One of the first criteria we consider is a stock's Quadrix Overall score, preferably above 80. Using that threshold lets us chip off a huge chunk of the index, leaving us with 330 potential stocks.

• Then we demand strong operating momentum. Although the number of S&P 1500 companies currently growing profits and revenue is consistent with historical norms, relatively few have delivered strong growth, as shown in the chart below. With that in mind, we excluded stocks generating less than 10% growth for both per-share profits and revenue over the last year, reducing our block to 106 stocks.

• We also like to see rising operating cash flow and free cash flow, which shrinks the number of candidates to 67 stocks.

• To avoid overpaying for that growth, we chiseled off stocks that trade above their sector medians for either trailing P/E or current-year P/E ratios. By doing so, we cut our group to 32 stocks.

• Ideally, our top stocks stack up well versus peers from other angles, as measured by our sector-specific Quadrix scores. Just 14 stocks that meet the earlier criteria also score above 80 for both sector-specific ranks.

• Finally, we want to avoid stocks with potentially fatal flaws, such as financial instability, falling profit estimates, and weak share-price action. Ensuring that the stocks have no weak spots, as in Quadrix category scores below 40, leaves us with just nine stocks.

Among this final and finely chiseled group of nine stocks, the Forecasts recommends all three of the large-caps: Applied Materials ($45; AMAT), Citizens Financial Group ($37; CFG), and Lam Research ($155; LRCX).

The other six stocks have market capitalizations below $6 billion, generally too small for us. Sister publication Upside recommends two of these smaller stocks: Cirrus Logic ($65; CRUS) and Thor Industries ($103; THO). Both are rated Best Buy.

In the table below, we chipped away at our list of recommended stocks by applying the same criteria used for the S&P 1500 Index. It's worth noting that ON Semiconductor ($15; ON) also clears all six hurdles but is not a member of the index.

Four of our favorite stocks are reviewed below.

Applied Materials ($45; AMAT) has a stock-market value of $49 billion, nearly twice the size of the second-largest stock in the S&P 1500 semiconductor-equipment industry. Yet it is generating the growth normally reserved for far smaller companies. For the 12 months ended April, Applied Materials has grown per-share profits, revenue, operating cash flow, and free cash flow at least 35%. Just nine other stocks in the S&P 1500 Index have delivered such strong growth on all four metrics — and among the nine only Facebook ($159; FB) and Chubb ($144; CB) have market values above $6 billion.

Situated in a highly volatile industry, the stock's growth prospects remain firmly intact. Applied Materials expects customers to keep upgrading their equipment to keep pace with rapid advancements in smartphone screens. Management's July-quarter guidance was more bullish than analysts anticipated. Growth target ranges have midpoints of 63% for earnings per share and 30% for sales. For the October quarter, analysts expect 23% higher profits on 12% revenue growth. Applied Materials is a Buy and a Long-Term Buy.


Citizens Financial Group ($37; CFG) shares, moribund for much of the year, have surged 7% in the past 3 months. The stock rallied in late June after Citizens announced plans for a pair of dividend hikes over the next six to eight months, boosting the distribution by a total of 57%.

June-quarter expectations are modest for large banks, as investors brace for a sluggish deal environment, lower trading revenue, and soft loan growth. Of those three developments, only loan activity will likely affect Citizens Financial. In April, management's June-quarter guidance seemed conservative, projecting loans to climb 1.5% from March-quarter levels. Citizens Financial is expected to report earnings per share of $0.59, up 28%, on 9% higher revenue. Results are due July 21.

Investors will also be looking for clues about management's confidence in its prior target of loans growing 5.5% to 7% for the year. The Federal Reserve's interest-rate hike in June, its second such increase in 2017, should boost the bank's profitability in the second half of the year. Citizens Financial is a Focus List Buy and a Long-Term Buy.


Swept up in the technology sector's broad slump, Lam Research ($155; LRCX) shares have dipped 3% in the past month. Yet the stock has roughly doubled since we initiated Lam as a Buy and Long-Term Buy in August 2014 and remains up 47% in 2017 alone. Despite that rally, Lam earns a Quadrix Value score of 73, while also looking cheap versus peers.

Historically, investment in semiconductor equipment has been lumpy and highly cyclical. However, spending has become unusually steady since the Great Recession, possibly due to structural changes in the maturing semiconductor industry. Lam has hinted that industrywide spending on wafer-fabrication equipment for 2017 could reach the higher end of its range of $35.5 billion to $39.5 billion, versus slightly more than $34 billion in 2016. It expects 2018 spending to remain strong. Lam is a Focus List Buy and a Long-Term Buy.  


ON Semiconductor ($15; ON) products appear in a broad range of end markets, such as automotive (34%), industrial (19%), communications (16%), computing (12% of sales), and consumer products (12%). Although based in Arizona, ON is excluded from the S&P 1500 Index, likely due to its low exposure to the U.S., which represents just 15% of its revenue and 25% of fixed assets. Its 12-month sales (up 31% to $4.53 billion), operating cash flow (up 34% to $675 million), and free cash flow (up 117% to $484 million) all stand at record highs, helped by the September acquisition of Fairchild.

ON shares have climbed 17% in 2017 but still look cheap at 16 times trailing earnings, a 25% discount to the median S&P 1500 technology stock. At just 12 times estimated 2017 profits the stock trades 44% below its sector median. Analysts expect ON to report 52% higher per-share profits for the June quarter and 42% growth for the year. ON is a Focus List Buy and a Long-Term Buy.

DRILLING DOWN INTO OUR STOCKS
Below, we repeated the exercise, this time using our recommended stocks. A total of 27 of 34 recommended stocks clear the first hurdle of having Overall scores above 80. Just four stocks meet all six criteria: Applied Materials, Citizens Financial Group, Lam Research, and ON Semiconductor.
------- 12-Month Change -------
-- Trailing P/E --
-- Curr.-Yr. P/E --
-- Quadrix Scores --
Company (Price; Ticker)
Quadrix
Overall
Score
EPS
(%)
Sales
(%)
Operating
Cash Flow
(%)
Free
Cash
Flow
Stock
Discount
(Premium)
To Sector
Median
(%)
Stock
Discount
(Premium)
To Sector
Median
(%)
12-
Factor
Sector
Reranked
Overall
No. Of
Quadrix
Category
Scores
Below 40
Overall scores above 80 . . .
Alaska Air Group
($95; ALK)
95
0
12
(17)
(49)
134
40
12
45
87
98
0
Amgen ($173; AMGN)
92
11
3
12
8
15
35
14
36
24
92
1
Apple ($146; AAPL)
81
(4)
(3)
(2)
(7)
17
15
16
18
26
76
0
Carnival ($66; CCL)
94
29
5
7
13
19
(9)
18
(6)
40
92
0
CDW ($63; CDW)
85
25
6
4
3
18
11
17
16
12
85
1
Citrix Systems
($80; CTXS)
81
42
3
(5)
(1)
16
24
17
15
37
71
0
Comcast ($39; CMCSa)
86
13
9
6
2
21
(21)
20
(18)
77
74
1
EQT Midstream Part.
($76; EQM)
94
6
18
NA
NA
14
50
14
35
48
100
1
Juniper Networks
($29; JNPR)
97
1
5
75
137
13
34
13
34
91
93
1
Lear ($148; LEA)
97
25
3
(1)
(11)
10
43
9
45
88
90
1
Mohawk Industries
($248; MHK)
93
17
8
23
11
19
(10)
19
(11)
50
90
0
Royal Caribbean
($110; RCL)
98
25
2
42
42
17
3
15
9
33
97
0
Snap-on ($153; SNA)
84
13
5
12
16
16
26
15
27
83
82
2
Southwest Airlines
($62; LUV)
97
(6)
2
26
57
18
19
16
23
87
96
0
VMware ($89; VMW)
95
NA
8
26
36
18
12
18
9
93
88
0
. . . and 12-month EPS and sales growth above 10% . . .
D.R. Horton ($37; DHI)
95
17
16
(50)
(70)
14
27
13
19
83
87
0
FedEx ($218; FDX)
99
62
20
(14)
NA
18
20
16
23
94
100
0
Lowe's ($76; LOW)
89
12
11
3
0
18
(6)
17
0
80
75
1
Owens Corning
($66; OC)
95
29
10
(7)
6
17
25
16
25
94
97
0
… and 12-month operating-cash-flow and free-cash-flow growth . . .
Facebook ($159; FB)
87
128
53
84
101
33
(60)
32
(60)
78
84
1
Zions Bancorp
($45; ZION)
95
80
14
NA
NA
20
(12)
18
(7)
97
81
0
. . . and P/E ratios below sector medians . . .
Celgene ($134; CELG)
84
80
21
48
57
21
7
18
17
58
79
0
. . . and both sector-specific Quadrix scores above 80 . . .
Centene ($83; CNC)
100
31
84
259
300
18
22
17
21
100
100
1
. . . and no Quadrix category scores below 40
Applied Materials
($45; AMAT)
99
122
35
123
224
17
14
15
26
84
100
0
Citizens Financial
($37; CFG)
98
31
12
NA
NA
17
4
15
9
83
96
0
Lam Research
($155; LRCX)
99
55
24
41
55
18
12
16
21
94
99
0
ON Semiconductor
($15; ON)
97
14
31
34
117
16
24
12
44
93
97
0
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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