Quadrix Fine-Tuned


In explaining our Quadrix® stock-rating system, we make a big deal of the fact that its design was not based on a back-test. We did not “reverse engineer” a system based on factors that have worked in the past. We designed a system that scores stocks the way we look at them, rewarding names with strong operating momentum, cheap valuations, good track records, rising profit estimates, and superior share-price strength.

Quadrix’s balanced and forward-looking approach has worked nicely since its March 2000 introduction, as shown in the chart above. Still, we’re always looking for ways to improve, and back-tested results are among the tools we consider when adjusting the factors and weightings used in Quadrix. Based on our real-time experience, back-tested results since the early 1990s, and common sense, we made several adjustments on June 30. Some of the more notable changes:

Among the six category scores, we lifted the weight assigned to Value while reducing the weight assigned to Quality. In both real-time and back-tested results, Value has been the most effective category score. Quality has been the least effective. Back-tested returns and recent results suggest we should take the weight for Value even higher. But we don’t want Value to dominate the Overall score, and we would not be surprised if the relative effectiveness of Value diminishes somewhat in the near term. As always, no category accounts for more than 40% of the Overall score, reflecting our emphasis on stocks with both attractive valuations and strong fundamentals.

The weights for Earnings Estimates and Performance were lifted slightly, and the weight for Financial Strength was reduced slightly. The Performance score has delivered good results in back-tests to the early 1990s, though returns are quite volatile. The forward-looking nature of Earnings Estimates and Performance make them a nice complement to the backward-looking bias of most Quadrix variables.

In the Earnings Estimates category, we lifted the weights assigned to net revision ratios, which compare the number of profit estimates raised to the number lowered over a given time period. Since the 2004 introduction of the Earnings Estimates score, net revision ratios have been more effective than variables that measure the percentage change in the consensus estimate. Also, we put more weight in Earnings Estimates variables based on four-week changes — and less on 12-week changes. Our adjustments are likely to result in more volatile (and more timely) Earnings Estimates scores.

The table below provides Quadrix Overall scores on all of our Buy and Long-Term Buy recommendations. Our Web site, provides access to scores on more than 4,000 U.S.-traded stocks, along with sector and industry averages. Below, five Quadrix standouts are reviewed.

Apple’s ($252; AAPL) Quadrix Overall score of 98 reflects a sterling balance sheet ($24.29 billion in cash and no long-term debt), strong growth trends (annualized five-year growth of 36% for sales and 67% for operating profits per share), and surging profit estimates (calling for 53% higher per-share profits in fiscal 2010 ending September, up from the 46% expected a month ago). At 18 times trailing earnings, the shares are no bargain. But Apple’s outsized growth potential warrants a premium valuation.

There is one worm in the apple. Consumers have complained about problems with reception and dropped calls on the most recent iPhone model, and Consumer Reports magazine has refused to endorse the product. The company acknowledged that the antenna sometimes malfunctions when callers grip the phone. Apple responded by offering free protective cases. Despite the problems, demand has outstripped supply.

In the June quarter, Apple earned $3.51 per share, up 75% and $0.39 above the consensus estimate. Revenue jumped 61% to $15.70 billion. In the quarter, Apple sold a record 3.47 million Macintosh computers (up 33% from year-ago levels) and 8.4 million iPhones (up 61%). The company also sold 3.27 million iPad tablet computers. The robust sales numbers may actually understate revenue potential, as Apple probably could have sold even more iPhones and iPads if supply had kept up with demand. Apple is a Long-Term Buy.

Earning an Overall score of 93, Comcast ($19; CMCSa) doesn’t stand out in any one Quadrix category. But neither does it suffer from a major weakness, with all six category scores above 60. The cable provider continues to find more customers willing to pay for its premium services, driving free-cash-flow growth in eight of the last 10 quarters.

A pending merger deal with NBC Universal has provoked concern among competitors and legislators, with some calling for the sale of the CNBC network and Hulu.com, an online video site. Comcast anticipates the U.S. regulatory review will stretch until late 2011. Doubts about the deal seem to be priced into the stock, trading at 15 times trailing earnings, 29% below the three-year average.

Comcast is slated to report June-quarter results on July 28. Wall Street anticipates earnings of $0.32 per share, down 3% on 4% sales growth. Full-year 2010 earnings are expected to be flat, but per-share earnings should bounce in 2011. Comcast has topped the consensus in each of the last four quarters. Its shares up 12% for the year, Comcast is a Focus List Buy and a Long-Term Buy.

DirecTV ($36; DTV) earns an Overall score of 93, boosted by outstanding scores for Momentum and Quality. Free cash flow has risen in nine of the past 10 quarters, up by no less than 47% in each of the past four quarters. That operating momentum sustains an aggressive share-repurchase strategy. The share count has fallen more than 18% over the last two years.

Profit estimates for 2010 have fallen slightly over the last month, and we would prefer to see more positive trends as DTV nears the release of June-quarter earnings on Aug. 5. But the consensus still calls for 50% higher per-share earnings for the quarter and 63% for the year. Over the next five years, Wall Street sees profits rising at an annual rate of 22%. The stock trades at a PEG (price/earnings-to-growth) ratio of just 0.7, less than half of the average of 1.5 for stocks in our Quadrix research universe. DirecTV is a Focus List Buy and a Long-Term Buy.

Newmont Mining ($59; NEM) operates projects on five continents. The company derives most of its sales from gold, though copper is becoming a bigger factor because of two mines starting this year.

The stock’s Overall score of 99 is powered by ranks above 90 in four Quadrix categories: Momentum (99), Earnings Estimates (98), Quality (92), and Performance (91). Robust gains in sales, earnings, and cash flow in the March quarter extended a multiyear trend of strong growth.

June-quarter results, due July 28, are expected to show profits of $0.87 per share, more than twice the year-ago level. Despite strong operating and profit-estimate momentum, Newmont shares trade at 18 times trailing earnings, well below the three-year average P/E of 27. Newmont is a Focus List Buy and a Long-Term Buy.

TJX ($42; TJX) dodged the recessionary potholes that upended many retailers in 2009. The discounter grew same-store sales for most of the year while generating higher returns on assets and equity. The recent momentum underscores long-term trends, as TJX has reported 15 consecutive years of higher per-share profits, sales, and cash flows. Rising free cash flow has helped TJX aggressively buy back shares, shrinking the share base 13% over the last three years.

TJX operates about 2,800 stores in the U.S., Canada, and Europe. Management believes it can grow to 4,200 stores, with the greatest expansion opportunities in Europe. TJX also plans to launch its successful Marshalls franchise in Canada next spring. Per-share profits are projected to grow 18% in fiscal 2011 ending January and 14% annually over the next five years.

The shares took a hit when management, in reporting June sales, provided profit guidance below the consensus. Nevertheless, the announcement prompted some analysts to raise their profit estimates, causing the consensus for this year and next year to edge upward. Earning an Overall score of 99, TJX is a Buy and a Long-Term Buy.

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