Strong And Steady Wins The Race
In the Oct. 26 issue of the Forecasts, we showed how stocks with persistently high Quadrix® Overall scores outperformed not only the average stock, but the average high-scoring stock.
Those findings, while impressive, left us with a couple of questions:
• Does the volatility of Quadrix Overall scores — or the lack of it — factor into the strong returns of consistently high scorers?
• Would a strategy of focusing on stocks with the least-volatile Overall scores enhance returns and lower portfolio turnover?
This week, we attempt to answer those questions.
Because Quadrix relies on such statistics as stock-market returns, valuation ratios tied to the stock price, and profit-estimate revisions, Overall scores can be quite volatile. However, the volatility of Overall scores varies greatly from stock to stock.
Looking for low volatility
Our research suggests companies with the steadiest Overall scores tend to outperform. In rolling 12-month periods since 1994, S&P 1500 Index stocks earning Overall scores of 80 or more averaged a return of 13.6%. Within that group, the 50 companies with the least-volatile Overall scores over the last 12 months averaged a 16.6% return, while the 50 with the most-volatile Overall scores averaged a return of 10.7%.
To determine volatility of Overall scores, we calculated the standard deviation of each stock’s scores over the trailing 12 months. Standard deviation reflects how widely the scores are dispersed around the average. We also considered share-price volatility, determining that portfolios of stocks with low volatility for Overall scores generated returns of roughly similar volatility as those of portfolios containing stocks with high volatility for Overall scores. In other words, investors need not take on much extra risk to earn these extra returns.
Not too much turnover
In general, the more tightly you craft a stock screen, the more stocks in the group will fall short of the requirements over time. On average since 1994, investors who purchased all S&P 1500 stocks with Overall scores of 80 or higher and held them for a year would have had to replace 53% of the stocks to reconstitute the portfolio using the same criteria. A portfolio containing just the one-fifth of high-scoring stocks with the least-volatile Overall scores averaged nearly 70% turnover. However, the smaller size of the second portfolio makes the turnover manageable from a cost standpoint, as shown in the table below.
We should expect higher turnover from portfolios dependent on screens with strict criteria. But while 70% turnover may sound high, the focus on low-volatility stocks actually reduces turnover. Portfolios containing the one-fifth of high-scoring S&P 1500 stocks with the highest volatility of Overall scores averaged annual turnover of nearly 99%.
One of the difficulties inherent in purely quantitative investment strategies is cost, partly because Quadrix works best when we apply it over large groups of stocks. While stocks with high Overall scores tend to outperform low scorers, the trend is not absolute — some top scorers will perform poorly. The best protection against such outliers is using a portfolio with all the high scorers, overwhelming the losers with a larger number of winners. Unfortunately, that is not always practical.
Of the current components of the S&P 1500, 378 earn scores of 80 or higher, while 181 score at least 90. Even if investors were confident that buying all the high scorers would generate market-beating returns, most individuals lack the resources to purchase so many stocks and the time to follow them. But scale those portfolios down to the one-fifth with the lowest volatility of Overall scores, and the numbers make more sense for investors despite the higher turnover percentage.
In the table below, we list 19 recommended stocks with high Overall scores that have seen below-average volatility in that score over the last 12 months. Three of those companies are reviewed in the following paragraphs.
Cognizant Technology Solutions ($46; CTSH) scores in the top 13% of stocks in our research universe in five of the six key Quadrix categories. Its sole low score, a Value rank of 46, is mostly a function of the stock’s success. The shares have bounced 153% so far this year. While not cheap at 27 times trailing earnings, Cognizant trades at a 28% discount to the five-year average P/E ratio and appears capable of additional gains in the year ahead.
Cognizant builds custom software applications and manages computer systems. In the September quarter, the company boosted revenue across all industry sectors, geographies, and service lines. After a wave of consolidation, key financial clients have said that the worst of their technology budget cuts are over.
Cognizant said it added five new clients in the quarter that it believes can each potentially contribute $5 million to $50 million in annual revenue. Bolstered by the resumption of spending, Cognizant appears poised to stretch its streak of double-digit sales gains to 13 years. Revenue advanced 15% in the first nine months of the year, and Wall Street anticipates 18% growth in the December quarter. Cognizant is a Focus List Buy and a Long-Term Buy.
Through the first nine months of 2009, General Dynamics ($68; GD) posted 22% sales growth in combat systems, versus 15% for marine systems and 9% for information systems and technology. The aerospace unit managed flat sales despite an extremely weak market for business jets. Total backlog rose to $66.25 billion in the September quarter, up 10% from a year earlier. Despite recessionary pressures, General Dynamics’ revenue growth should come as no surprise. More than 10 years — 41 quarters to be precise — have passed since General Dynamics reported a decline in quarterly sales.
Since the end of September, General Dynamics has announced more than $2 billion in new contracts and extensions, primarily from U.S. government programs. Even so, constraints on the U.S. military budget have left General Dynamics and other defense companies eyeing opportunities abroad. General Dynamics is a Buy and a Long-Term Buy.
From an operational standpoint, Oceaneering International ($59; OII) depends on the success of offshore drillers, which have had a busy year. Oil discoveries are on pace to reach the highest levels since 2000, with many of the biggest finds in the ocean’s deepest regions. Oceaneering shares, however, tend to follow the fluctuations of oil prices, which have more than doubled from a low of $34 a barrel last December.
Many market watchers expect per-barrel oil prices to rise another 10% to 20% over the next year, lifted by higher demand, though prices could dive if the recovery stalls. Climate-control legislation and improved energy efficiency could also limit the growth of energy consumption. While Oceaneering shares have jumped 102% so far this year, they remain reasonably valued at 17 times trailing earnings, 13% below the five-year average price/earnings ratio. Oceaneering is a Focus List Buy.