Don't Sacrifice Quality To Play Trend
With stock prices up sharply despite continued economic weakness, what is a momentum investor to do?
Strategies based on price action alone don’t make sense, as many of the stocks that paced the rally from March lows have weak fundamentals and seem due for a pullback. In today’s environment, momentum investors can improve their odds with our Quadrix® stock-rating system.
Companies with strong Quadrix Overall scores tend to deliver superior returns. The Overall score works because it reflects nearly 100 statistics of various types, including measures of valuation, growth, financial strength, profitability, earnings-estimate trends, and stock-price action.
The diversified approach that makes the Overall score so effective may not resonate with investors who put a lot of value on short-term performance and estimate revisions. However, Quadrix can help find stocks with solid fundamentals as well as favorable share-price and estimate trends.
Stocks with Overall scores above 80 that also earned high Performance and Earnings Estimates scores have outperformed the average high Overall scorer based on back-tests from February 2004, when we first began calculating the Earnings Estimates score. The higher the Performance and Earnings Estimates scores, the higher the returns.
While both the Performance and Earnings Estimates scores have predictive value, investors should know their limitations.
The Performance score considers a stock’s return over periods ranging from one to 12 months. Consistent overachievers rise to the top. However, the Performance score does not consider fundamentals, and it can provide a false positive when low-quality stocks rally. The Earnings Estimates score helps investors find companies with rising estimates — which doesn’t always mean profits are growing.
To make the wisest use of Performance and Earnings Estimates scores, consider them only after you have eliminated companies with weak fundamentals. Start with the Overall score, then move on to Performance and Earnings Estimates.
The linked table lists 20 stocks with solid Performance and Earnings Estimates scores. Three of our favorites are reviewed below.
Over the past 30 days, all of the 16 analysts whose projections make up the Dolby Laboratories ($39; DLB) consensus profit estimate have hiked their forecasts for fiscal 2009 ending September. The consensus has climbed $0.11 to $1.88 in that time, implying 8% year-to-year growth. Despite the strong outlook, Dolby shares trade at 20 times expected profits for the year ending September, roughly in line with the three-year average forward P/E ratio and reasonable considering the company’s growth potential.
In the next few quarters, revenue may dip as consumer demand for electronics softens, but the long-term story remains intact — and that outsized growth potential should keep investors interested in the stock over the next year. The market for portable electronic devices, many carrying Dolby’s surround-sound technology, should expand considerably in coming years. Future revenues are also supported by momentum in international digital TV as European countries shift away from analog broadcasting. In addition, software giant Microsoft’s ($20; MSFT) Windows 7 operating system, slated for release before the holidays, features Dolby’s DVD-playback software.
Dolby has a strong growth history, as evidenced by a Quadrix Quality score in the top 1% of our research universe. A robust balance sheet carries less than $7 million of long-term debt versus cash of $566 million, or $4.92 a share. Free cash flow surged 41% in the past 12 months. Dolby is a Focus List Buy.
On May 13, IBM ($106; IBM) reiterated 2009 earnings guidance of at least $9.20 per share, up 3%. Wall Street has doubted IBM’s projection ever since the company first released the number in January — the consensus calls for profits of $9.12 per share, though it is trending higher. The long-term profit picture also looks promising, as Wall Street expects annualized profit growth of 11% over the next five years.
IBM’s confidence lies partly in its ongoing shift from the volatile hardware market toward software and services, which provide a steadier revenue stream. Software and services combine to represent about 80% of sales, up from 50% in 2000, and that percentage is likely to keep rising. The company says 70% of its software revenue is annuity-like in its consistency.
IBM is not entirely immune to the downturn. Sales declined 11% in the March quarter, though cost cuts helped drive per-share profits up 4%. The stock is up 27% so far this year, versus a gain of less than 1% for the S&P 1500 Index. The company earns a solid Quadrix Performance score of 73 to go along with its 91 Overall. IBM is a Focus List Buy and a Long-Term Buy.
Leveraged to deepwater drilling, Oceaneering International ($49; OII) has rallied in recent weeks, helped by a rise in the price of oil. The shares are up 77% from March lows. Oceaneering’s stock has jumped 11% since April 29, when it posted quarterly results.
In the March quarter, revenue was roughly flat at $435 million, though growth in remotely operated vehicles (ROVs) and subsea projects topped expectations and fleet utilization held at 80%. Wall Street expects per-share profits to slip 8% in 2009 and rebound 6% in 2010, though the consensus estimates for both years are rising. Both projections look conservative.
Much of Oceaneering’s future growth should come from ROVs (32% of sales and 48% of operating income in the last four quarters). The fleet should expand 8% to 10% in the next three quarters, and further expansion is likely going forward. Oceaneering has secured contracts for nearly all of these new ROVs.
Over the next five years, Oceaneering predicts Brazil will offer the greatest growth for deepwater drilling, fueling demand for Oceaneering’s products, especially umbilicals (tubes used to pump oil). Oceaneering is already discussing potential contracts with Petrobras ($40; PBR), Brazil’s national oil company. Oceaneering, which earns Quadrix scores above 90 for Overall, Performance, and Quality, is a Focus List Buy.