Using a proprietary quantitative strategy, Richard Moroney, editor of Dow Theory Forecasts, begins with 4,800 stocks, ending with a select few that successfully pass through five screening stages. Here, he explains the methodology and highlights some favorites that pass these strict tests.
Steven Halpern: Joining us today is Richard Moroney, editor of Dow Theory Forecasts, a newsletter that is widely regarded as one of the industry’s highest quality publications. Thanks for taking some time to join us today.
Richard Moroney: My pleasure. Good to be here.
Steven Halpern: In your latest issue, you offer a fascinating glimpse into your stock selection process. In fact, you compare it to an obstacle course. Could you expand on that?
Richard Moroney: Yeah. We just wanted to give a, kind of, real-life example of the screening process that we use to pick new stocks for Dow Theory Forecasts, and the first part of our process is our Quadrix stock rating system.
Quadrix is a quantitative system that I developed that looks at nearly 100 variables across six categories, where we’re looking at operating momentum, recent growth in sales earnings, cash flow, changes in margins. We look at value, where we’re looking at PE ratios, price to cash flow ratios, price to free cash flow ratios.
We also look at valuations relative to historical norms, so, what’s the PE today versus the three- and five-year norms for PE would be one example there. We look at qualities of somebody’s track record and its returns on assets in investment. Financial strength, its profit margins, and balance sheet interest coverage.
Earnings estimates is the trend in consensus estimates, and we also look at the number of estimates going up versus down, and then performance, which is based, mostly, on returns of periods up to one year.
So, based on those six category scores, we come up with a weighted average of the overall score, and, generally, we’re always looking for stocks that score above 80, that is the top one-fifth.
Typically, we’re looking at new stocks, we’re trying to get better than that, and typically above 90, so, when you go through, get to the first stage of this process for Dow Theory Forecasts, we’re looking at companies that have a market cap of above $4 billion, and we’re looking for stocks with overall scores above 90.
That takes the universe of roughly 4,800 US-traded stocks down to, about, 168 stocks that have passed the first screen in Quadrix, so, it kind of shows you the power of Quadrix that takes a huge universe and, fairly quickly, whittles it down to a bunch of high-potential stocks.
Steven Halpern: So, after you’ve finished with stage one—and you’ve started with roughly 4,800 stocks—how many are left after that initial stage?
Richard Moroney: Based on market cap and overall score, we’re down to 168.
Steven Halpern: Okay, and then those 168 you’ll put into stage two where you focus on growth. What happens in that step?
Richard Moroney: Growth is part of Quadrix, but, at this stage, we’re basically going back and saying is the company really growing, is there anything that would be misleading Quadrix, in terms of, you know, is there an acquisition boosting growth?
Is there something else that artificially is boosting growth? And then, as a bare minimum for this screen, we required sales growth of 5% and per-share profit growth of 10%, and we looked at that over the last 12 months and over the last three years.
That is not an iron-clad rule that we would use for all our recommendations, but it is—basically, we want substantial growers.
We want companies that are truly growing, and that’s roughly in line with what we’re kind of looking at as a minimum. When you do this, you go from 168 stocks down to 77 if you just screen for 5% sales growth and per-share profit growth of 10%, both over the last 12 months and over the last three years.
Steven Halpern: So then, in stage three, you focus on value, and again, you’ve mentioned that value is a consideration within the quantitative Quadrix system. What additional factors are you considering here when you want to make sure that these stocks meet the value goals that you have for them?
Richard Moroney: Right. The biggest thing here is, really, to kind of put the value in some context, so, Quadrix is comparing all US stocks on the same yardstick, so, when we look at value at this stage, we’re kind of looking at it with some industry context.
You know, how does it compare to its peers relative to its sector? How does it compare to the broader sector that it operates in? And compared to itself, how does the stock look relative to historical norms?
|pagebreak|There’s something that you can often do better with, you know, looking at one company at a time to, kind of, put it in perspective. Is this company truly cheap? Or is it just in a group that’s always kind of cheap and all the stocks are cheap?
What we did for this screen, we said, stocks that have Quadrix value scores that are above average both for our research universe and a price earnings ratio below the average of all stocks and below the stocks own five-year historical norm, so, in this case, it was a fairly easy screen to pass. We went from 77 at the end of stage two to 63 here.
All we really required was the stock was, kind of, a below-average valuation relative to all stocks and relative to its own historical norm. A lot of times we might get a little bit more nuanced at this stage, but for this screen that’s what we did, and it brought us down to 63 stocks.
Steven Halpern: Okay, and in stage four you focused on the stopped share price action. What specifically were you looking for there?
Richard Moroney: Right. At this—for this screen—what we did was just really look for some basic measures of out performance. The stock had a top, the average, had to be better than average on both year to date returns and 12-month total returns.
That’s not a screen we would always do, but we always do pay attention to the share price, performance, and if a stock has all these great numbers but the stock is eroding, that’s going to be a yellow flag for us.
Here we’re doing it in a fairly matter of fact kind of way and just saying, stock’s got to be above average both year to date and trailing 12 months.
Trailing 12 months is the total return factor that gets the most weight in Quadrix. It’s, generally, what I would consider the most important one, and that brings us down from 63 stocks at the end of stage three to now 44 stocks.
Steven Halpern: Okay. Now, the 44 stocks that have finally made it into stage four, you then screen for what you call estimate trends. Could you explain what this is?
Richard Moroney: Right. This particular screen we were looking for timely stocks. That’s why we’re using, you know, we went through the first three stages that we go through with all our stocks. Now we’re on stage four was share price performance.
Now stage five, another screen that we use for timely stocks is estimate trends. So we’re looking at, you know, how much has the consensus estimate risen over the last 90 days? And all we really required was that it had to go up at least 1% over the last 90 days.
We also wanted an earnings estimate score above 50, and, even though that sounds like a fairly simple screen, in this environment, where earnings estimates have been predominantly negative, that was pretty effective or restrictive screening. We went from 44 stocks at the end of stage four to 18 stocks at the end of stage five.
|pagebreak|Steven Halpern: So, you’ve gone from 4800 stocks. You’re now down to 18 once these five stages were completed. Now, we’d really appreciate it if you would share some of the names of those 18 that did make it through to give a representative idea to our listeners of the kinds of companies that are able to pass through this entire process and come out as the best potential performers.
Richard Moroney: Right. Yeah, I mean, the approach, really, once you get down to the 18, is really, kind of, roll up your sleeves and do individual company analysis.
Try and read company press releases and 10Qs and try and get a sense of whether past is likely to be prologue, like is the story that Quadrix and the other numbers are telling you already played out in the stock?
Is there something unusual that suggests that things are going to be different going forward than they have been? And that’s a little bit using the other side of the brain. It’s a little bit less quantitative.
Stocks that met all of our screens and were among the final 18 that we really like would include Alaska Air (ALK). Quadrix overall score is 99 out of a possible 100. It’s got tremendous operating momentum. It’s got rising sales, earnings margins.
It’s still cheap, trades at about 15 times trailing earnings, which is somewhat expensive, given how airlines have traded in the past, but it’s actually not that expensive for Alaska Air because they’ve generally been considered, you know, one of the safest, kind of, one of the Cadillacs of the group.
It’s got, really, everything we’re looking for, rising earnings estimates, cheap valuation, operating momentum, and it’s got an outlook where we can say, yeah, the company’s adding capacity, we can see earnings growing for another—at least through 2015.
In fact, I think estimates for the next 12 months are conservative and the company has a good chance to beat expectations.
Foot Locker (FL) is another one, similarly sized company, another mid-cap that we have on Dow Theory Forecasts. Overall score of 97. Sales growth not quite as dynamic.
Its sales over the last 12 months have been growing about 4% to 5%, but margins have been expanding, per-share profits up 13% over the last 12 months. Still cheap. Not an absolute bargain, but, at a trailing PE of about 16 now, it’s pretty cheap, and it’s cheap versus its own history, and it looks pretty good relative to other retailers.
What I kind of like is, the kicker there, is their exposure to Europe. As consumer sentiment and spending improves there, I think the potential for them to surprise people with some, just modestly improved results in Europe could render the consensus expectations for the next several quarters conservative.
Yeah, another one I like quite a bit, a bigger company, a large-cap, is Magna International (MGA). Its overall score is 99. It’s got double digit sales and earnings growth over the last 12 months. PE is still 13. Stock has been outperforming on rising profit estimates.
Obviously, people are scared of auto parts—always—because it’s a very cyclical sector, and they’re scared the boom’s going to end. I think there’s some drivers for Magna International that will allow it to outperform as long as auto production is rising.
Now, obviously, this company is going to have a hard time swimming upstream if the auto industry goes into a real downturn, but I don’t see that on the near term horizon.
I think Magna International’s position to keep gaining market share—company came through with another impressive quarter in the March quarter, and that’s one that we have on our focus list, which is our list of top stocks for Dow Theory Forecasts.
Steven Halpern: Well, we really appreciate you taking the time and sharing your ideas with us today.
Richard Moroney: Sure! My pleasure.
