Rising Quadrix, Rising Returns


Cars have rear-view mirrors for a reason.

Stock markets look forward, valuing companies based on what they are likely to do in the future. Investors should spend most of their time looking at the road ahead — you cannot drive safely just looking at the rear-view mirror. But neither can you drive safely without using the rear-view mirror from time to time.

Our Quadrix® rating system paints a detailed and accurate picture of a stock at a given point in time. We’ve done enough research to say with confidence that stocks with high Quadrix Overall scores tend to outperform low scorers in the year ahead. But the scores change, affected by ebbs and flows in the data that make up the scores. Our research suggests that stocks with rising Quadrix scores also tend to outperform the average stock. And the bigger the rise, the greater the outperformance.

In rolling 12-month periods since 1994, stocks in the S&P 1500 Index averaged a total return of 11.8%, with a geometric average of 10.2%. The geometric average reflects annualized compound gains over time. In contrast, stocks for which scores rose over the past three months averaged a gain of 12.2%, with a geometric average of 10.7%.

While changes in Quadrix scores can help predict stock returns, they have limitations. Below are three lessons learned from our research

Faster is better. In general, the quicker the increase, the higher the average return. For example, S&P 1500 stocks with 20-point increases in Overall score over three months averaged a return of 12.6% in the 12 months after the score rose. When Overall scores rose 20 points in one month, returns averaged 14.2%. However, while Overall scores change constantly, 20-point jumps in short periods of time are not common. In monthly observations over the last 14 years, S&P 1500 stocks managed a 20-point jump in one month only 1.3% of the time. In three-month periods, stocks rose 20 points 4% of the time.

Rising Quadrix no substitute for quality. While increasing Quadrix scores are a sign of investment appeal, don’t go overboard. Without considering whether scores rose or fell, stocks earning Overall scores of 80 or more averaged a 15.4% return. That’s higher than the return of stocks with scores that rose from a lower score to above 80, no matter how quickly or sharply they rose.

This data suggests that the raw Overall score is a more useful indicator of investment appeal than the rise in scores. However, rising scores may be a sign that prospects are looking up.

Some industries look better than others. As the chart at the end of this page illustrates, Quadrix changes vary greatly by industry. The wireless-telecommunications industry has seen the greatest increase in average Quadrix Overall score over the past month, earning a 56 now versus 36 a month ago. Conversely, the office-electronics, oil & gas, Internet & catalog retail, and real-estate industries averaged declines of at least 10 points. This data harks back to our discussion of quality stocks. While the average thrift’s Overall score has jumped over the past month, the industry averages a score of just 38, well below average. In other words, the scores have moved higher but are still not very good, and investors should stay away from the group.

Curious about whether certain stocks have seen Quadrix Overall scores rise in recent months?

In our view, the best way to capture the power of rising Quadrix scores is to start with a group of stocks already poised for excellence — high Quadrix scorers. The linked table lists six Forecasts monitored stocks with Overall scores that have trended higher in recent months. Three of those companies are reviewed in the following paragraphs.

Despite a difficult economic climate, Accenture ($30; ACN) has reported higher revenue and operating profit margins. The strengthening U.S. dollar has weighed on results, as Accenture generates more than half of revenue overseas. Management lowered its revenue-growth outlook for fiscal 2009 ending August to 6% to 10%, down from 9% to 12%. Still, demand for Accenture’s consulting and outsourcing services remains healthy, and consensus estimates project per-share-profit growth of 5% this year and 8% next year, targets the company should exceed if conditions improve.

In both good times and bad, companies use Accenture’s services to cut costs and increase efficiency. With 200 offices in 52 countries serving clients in 17 industries, Accenture boasts a diversified business mix that should hold up fairly well in the current environment. According to published reports, the company may acquire the Asian business of rival BearingPoint, a deal that would bolster Accenture’s operations in key Asian markets. Accenture is a Focus List Buy and a Long-Term Buy.

Airgas’ ($33; ARG) aggressive acquisition strategy has accounted for much of its growth in recent years. As smaller competitors grapple with economic headwinds, Airgas has the resources to continue making acquisitions at reasonable prices. The largest independent U.S. distributor of industrial, medical, and specialty gases, Airgas controls more than 20% of the fragmented industry.

Airgas’ size, unusually well-trained salesforce, multiple distribution channels, and diverse customer base provide a competitive edge. In addition, the company continues to expand its product line, which includes many high-margin specialty gases. Demand across most of Airgas’ customer base has slowed, though the medical and food and beverage markets remain relatively strong.

Operating profit margins widened last year, lifted by cost controls and some price increases. Management also plans to cut back on capital spending after it completes significant plant projects in the March and June quarters. Airgas is a Focus List Buy.

Both the stronger U.S. dollar and a decline in hospitals’ capital spending have dragged on Stryker’s ($34; SYK) sales. Demand for medical and surgical equipment has weakened. But sales of orthopedic products, accounting for about 60% of total revenue, have been solid. Still, after eight consecutive years of double-digit sales growth, management is forecasting growth of 6% to 9% at constant currency in 2009. Profit-growth prospects remain strong — consensus estimates project per-share earnings will rise 10% in 2009 and 13% in 2010.

Stryker maintains a tight lid on expenses, which helps profitability. At the end of 2008, the company had $2.2 billion, or $5.54 per share, in cash. Management said the company would consider an acquisition to expand its business but would not take on a significant amount of debt. Stryker is a Buy and a Long-Term Buy.

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