How The Pros Pick Stocks

9/7/2009


The Quadrix® system, which evaluates more than 100 statistics to create percentile rankings for roughly 4,200 stocks, serves as our first screen. By scrapping any stocks that earn an Overall Quadrix score below 80, we remove more than 3,200 companies from consideration in a single step. But that still leaves more than 800 candidates.

All of our analysts use Quadrix. But the Forecasts’ research staff has more than 70 combined years of investment experience, and our experts lean toward different individual metrics to further pare down a list of high-quality stocks.

The following paragraphs — and the tables — provide a peek behind the curtain at six of the metrics we track most closely and the qualities we want to see in a company. For each metric discussed below, we identified five intriguing stocks (see the tables), of which one is detailed in the text.

Financial fortitude

In a recession, there is no better protection than cash. Cash can help companies avoid high interest rates and tight credit markets while sustaining dividend growth and stock buybacks. We screened for stocks with Financial Strength scores above 85 and long-term debt less than 25% of total capital. Companies in the nearby table have also lowered their debt burdens in the past year, without exhausting their cash surplus.

National Oilwell Varco ($36; NOV), which builds and provisions drilling rigs, has increased its cash by 38% in the past year to $2.29 billion, or $5.47 per share, enough to cover nearly two years of operating expenses. In the same period, long-term debt has fallen 37% — and now represents just 6% of total capital. With a Financial Strength score of 88, National Oilwell Varco is a Buy and a Long-Term Buy.

FINANCIAL FORTITUDE
——— LT Debt ———
Company (Price; Ticker)
% Of
Total
Capital
1-Year
Change
(%)
Cash Per
Share
($)
Quadrix
Financial
Strength *
CA ($22; CA)
22
(42)
5.52
87
Johnson & Johnson ($60; JNJ)
15
(7)
5.29
90
National Oilwell ($36; NOV)
6
(37)
5.47
88
Oceaneering Int'l ($52; OII)
11
(38)
0.90
88
Precision Castparts ($90; PCP)
5
(18)
4.48
97
* Quadrix scores are percentile ranks, with 100 the best.

Rallied on earnings

Simply exceeding the consensus profit estimate is not always enough to satisfy Wall Street. A stock’s movement following an earnings release is a good gauge of quarterly performance. We screened for companies that outgained the market by more than 4% in the first trading day after their most recent earnings release.

For the June quarter, Cognizant Technology Solutions ($35; CTSH) impressed investors by topping the consensus profit estimate by 27% and raising its 2009 guidance above Wall Street expectations. The shares jumped 10.3% on the news and have continued to rise, hitting a 13-month high in late August. Wall Street projects per-share-profit growth of 16% this year and 9% in 2010. Cognizant is a Focus List Buy and a Long-Term Buy.

RALLIED ON EARNINGS
1-Day Change On Earnings News
Company (Price; Ticker)
Stock
(%)
S&P
500
(%)
Sector
Index
(%)
Sector
Aflac ($38; AFL)
6.7
1.2
2.6
Financials
Cognizant Tech. ($35; CTSH)
10.3
0.3
0.0
Technology
IBM ($117; IBM)
4.3
0.0
0.9
Technology
NII Holdings ($24; NIHD)
10.6
2.3
2.6
Telecom Svs.
Oceaneering Int’l ($52; OII)
5.3
1.2
1.1
Energy

 

Declining share counts

Stock buybacks reflect confidence on the part of management and boost per-share growth by reducing the number of shares outstanding. Buybacks represent an increasingly popular tool for sharing the wealth with investors, more flexible than dividends because companies can more easily alter the pace of buybacks to adapt to market conditions. We screened for companies that have lowered their share count by more than 10% over the past three years.

AmerisourceBergen ($21; ABC) has trimmed its share count by 1% in the past year and nearly 28% over the past three years. Higher operating cash flow, up in three of the past four quarters, has helped fund the buybacks. Per-share profits rose 17% over the past 12 months and at an annualized rate of 23% over the last three years, helped by the lower share count. The shares trade at 13 times trailing earnings, about two-thirds of the five-year average P/E ratio. Amerisource is a Buy and a Long-Term Buy.

DECLINING SHARE COUNTS
Company (Price; Ticker)
Shares
Outstanding
(Million)
1-Year
Change
(%)
No. of
Decreases
Last 12 Qtrs.
3-Year
Change
(%)
AmerisourceBergen ($21; ABC)
301
(1.3)
12
(27.5)
Accenture ($33; ACN)
783
(0.5)
12
(11.7)
Hewlett-Packard ($44; HPQ)
2,436
(0.1)
12
(14.2)
Microsoft ($24; MSFT)
8,928
0.3
11
(12.9)
Exxon Mobil ($68; XOM)
4,871
(1.8)
12
(19.2)

 

Profit-margin improvement

We look for widening gross, operating, and net profit margins, each of which measures profitability from a different angle. Gross margin measures revenue relative to production costs, and improvement suggests more cash is becoming available to fund discretionary expenses, such as marketing and research and development. Operating margin measures income from business operations relative to sales. Net margin considers profits after all expenses, including taxes, have been paid. All five companies in the nearby table earn Quality scores above 80 and demonstrate some of the fruits of higher margins: solid growth in earnings, cash flow, and dividends.

A five-year plan to improve its supply chain has helped Sigma-Aldrich ($49; SIAL) expand gross, operating, and net profit margins in each of the last four quarters. Higher profit margins have offset weak revenue for Sigma-Aldrich, which sells more than 100,000 products used for drug research and chemical manufacturing. Wall Street expects Sigma-Aldrich to face tough profit comparisons this year, with per-share earnings rising just 2%. But the 2010 consensus calls for growth of 11%. With a Quality score of 89, Sigma-Aldrich is a Long-Term Buy.

PROFIT-MARGIN IMPROVEMENT
—– Profit-Margin, Last Quarter —–
Company (Price; Ticker)
Gross
(%)
Operating
(%)
Net
(%)
Quadrix
Quality
Score *
CA ($22; CA)
84.1
35.5
18.6
87
IBM ($117; IBM)
50.5
22.7
13.3
94
Oceaneering Int’l ($52; OII)
31.0
23.1
10.7
96
Sigma-Aldrich ($49; SIAL)
56.0
28.2
16.0
89
Wal-Mart Stores ($51; WMT)
27.3
7.6
3.4
84
* Quadrix scores are percentile ranks, with 100 the best.

Free-cash-flow momentum

Free cash flow, a measure of how much cash a company has left after covering both discretionary and nondiscretionary expenses, represents a useful check on the quality of earnings. Free cash flow equals cash provided by operations minus capital spending and dividends. All five companies in the nearby table delivered double-digit growth in free cash flow over the last 12 months, building on solid track records over the past few years.

DirecTV ($24; DTV) grew free cash flow 30% to $1.77 billion in the past four quarters. Strong cash flow gives DirecTV flexibility to explore new growth avenues, such as 3-D television, the NFL Sunday Ticket on the Web, and software that will help advertisers target their audience by geographic location. Trading at less than 20 times trailing earnings, a 5% discount to its three-year average P/E, the stock looks reasonably valued considering its strong market position. DirecTV is a Focus List Buy and a Long-Term Buy.

FREE-CASH-FLOW MOMENTUM
——————— Free Cash Flow ———————
Company (Price; Ticker)
Last Qtr.
($Mil.)
1-Year
Growth
(%)
12 Mos.
($Mil.)
3-Year
Annual.
Growth
(%)
Dolby Laboratories ($37; DLB)
23.5
36
283
43
DirecTV ($24; DTV)
47.5
30
1,771
23
Hospira ($39; HSP)
57.3
36
482
37
IBM ($117; IBM)
27.9
21
13,258
10
Laboratory Corp. ($69; LH)
3.3
13
669
7

Short-squeeze candidates

Short sellers sell borrowed shares in hopes of buying the shares back at a lower price and pocketing the difference. If a heavily shorted stock begins to rally, short sellers may cover their positions by buying back the borrowed shares. A chain reaction sometimes follows, with new buying begetting even more buying and pushing the stock price higher.
Short-squeeze plays are generally more abundant among small-cap stocks, but investors can find a few in the large-cap space. We screened for stocks with short ratios of more than two days. The short ratio approximates the number of days needed to buy back all shorted shares, based on three-month average trading volume. Furthermore, all five stocks have fairly high short interest relative to float, or tradable shares.

About 4.5 million shares of Laboratory Corp. of America ($69; LH), or 4% of tradable shares, have been sold short. The short ratio stands at three days. LabCorp has repurchased about $2.8 billion in shares since 2003, resuming buyback activity in the September quarter after pausing for three quarters to conserve cash. In August, the company completed a $107 million takeover of Monogram Biosciences, a maker of diagnostic products for HIV and cancer. LabCorp seems unlikely to experience a true short squeeze. But its relatively high short interest could translate into increased buying pressure down the road. LabCorp is a Buy and a Long-Term Buy.

SHORT-SQEEZE CANDIDATES
Company (Price; Ticker)
Shares
Sold
Short
(Mil.)
Tradable
(Float)
Shares
(Mil.)

Shares
Short
as % of
Float

Short
Ratio
(Days to
Cover)
DirecTV ($24; DTV)
77.5
976.2
8
7
Dolby Laboratories ($37; DLB)
5.0
53.1
9
9
Laboratory Corp. ($69; LH)
4.5
108.1
4
3
Sigma-Aldrich ($49; SIAL)
6.4
121.4
5
7
Stryker ($41; SYK)
11.3
282.0
4
5

 


Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com