Bona Fide Values
10/16/2015 10:00 am EST
Using a quantitative screening process, Richard Moroney isolates the market's best value opportunities. Here, the editor of Dow Theory Forecasts discusses his screening technique and highlights two current favorite value-based investment ideas, one a leading biotech and the other a play on semiconductors.
Steven Halpern: Our special guest today is Richard Moroney, editor of Dow Theory Forecasts. How are you doing today, Rich?
Richard Moroney: Good, thanks. Thanks for having me.
Steven Halpern: In your latest issue, you look at a variety of different ways to screen stocks based on your proprietary Quadrix rating system. To begin, could you give our listeners a broad overview of the Quadrix system?
Richard Moroney: Sure. I developed Quadrix around the year 2000 to kind of formalize some informal screening techniques we’ve used for a long time at Dow Theory Forecasts. The basic idea is to use a broad number of variables divided over six different categories.
The categories are momentum, where we’re looking at recent sales and earnings growth. Value, where we’re looking at things like price earnings, price sales, price cash flow ratios. We’re also looking at those ratios relative to historical norms.
Quality, where we’re looking at a company’s return on assets, track record. Financial strength, where we’re looking at profit margins, interest coverage, debt positions.
Earnings estimates, where we look at the trend in analysts’ estimates and we also look at the number of estimates going up versus the number going down.
And performance, where we look at total returns with periods up to 12 months rewarding stocks with superior share price action.
All these categories are not equally weighted. Value receives the biggest weight. It has been the most effective.
The other five categories often are more correlated with each other, so what you kind of have is this seesaw effect where the stocks that truly score best are companies with operating momentum and good track records, rising earnings estimates, and stocks that are outperforming, but are also cheap.
Stocks can get a good overall score several ways, but really, most often, they need to be strong across the board and that’s really what we’re looking for. We want companies that have as many arrows pointing up as possible.
What we do is, for example, those six category scores are combined into one overall score that is our main criteria and that’s what we call the overall score. We’re generally looking to buy stocks with overall scores above 90 and if stocks slip below 75 or 80 on the overall score then that prompts a reevaluation and possibly a sell.
Steven Halpern: Okay, so let’s hone in on one of these six Quadrix categories and that’s the value score, which you note has worked the best over long periods. Within the value score, you note that the price to earnings ratio is the most common valuation metric, but you also caution that this ratio has its flaws. Could you expand on that?
Richard Moroney: The biggest flaw, really, is that earnings are what companies are most inclined to inflate through accounting gimmicks, so they can skew earnings higher by accelerating sales in an artificial way.
They can understate their costs some ways, and because everyone is focused on that earnings number and because bonuses are often tied to earnings per share, companies will often try to boost that earnings number using accounting gimmicks. That’s the biggest flaw with using price earnings.
There are some other issues, in terms of, you can’t value companies that aren’t making money, companies that have a lot of leverage tend to sell at lower P/Es, and therefore, you kind of want to adjust for their capital structure in extreme situations when there’s a lot of debt.
But the biggest issue is that its the number companies are trying to inflate, so the price/earnings ratio can make some stocks look cheaper than they truly are. But it has worked well, I should note.
Steven Halpern: Now, to address those potential flaws in your system, you add a three-part screen to assess P/E ratios from several different angles. Could you walk us through this?
Richard Moroney: Sure. What we did was we also looked at the current price/earnings ratio relative to the stock’s five-year average P/E.
We’re actually looking at the last 60 months of P/Es, determining the median P/E over the last 60 months, and comparing the current P/E to the median P/E over the last 60 months and then that ratio gets compared to all the other stocks.
So, basically, a stock is going to be rewarded for this variable if its P/E relative to its historical norm P/E is unusually low relative to other companies. That’s a way for adjusting for stocks that are always cheap.
I mean, if you want to buy an aluminum company or somebody who’s selling agricultural inputs, their P/E is always going to look cheap. This is a way to kind of say is it cheap compared to where it usually is.
We also looked at the P/E versus the average for the sector. For example, Gilead Sciences (GILD) earned a very good value score is in the healthcare sector and its P/E now is going to be compared to all the companies in the broad healthcare sector.
We also looked at it on an industry basis. What’s Gilead’s P/E relative to the biotech group? And finally, we overlaid the overall value score in it and we insisted on a value score above 80.
The value score uses about 20 valuation metrics so it provides kind of a good check on whether a stock is truly cheap. You’ll have some stocks that look cheap on P/E, but they may score well in the other ones. By insisting on a Quadrix value score of 80, we’re kind of insisting that the stock has across the board cheapness.
Steven Halpern: Pulling all of this together, your screen began with the broad universe of stocks and then you’ve isolated those that you consider “bona fide values.” Could you walk us through a few of the ideas that made it through this whole screening process?
Richard Moroney: Sure, well, like I mentioned, our top recommendation on that screening that we presented in the newsletter was Gilead Sciences which is a biotech company.
The stock earned a value score of 93 out of a possible 100 so it’s in the cheapest roughly 7% of US-traded stocks. The stock is cheap because people are dubious that they can maintain the growth they’ve delivered.
There are concerns about how much they’re going to have to discount their drugs and there’s concern about their drug is so powerful that it cures people of hepatitis C and there’s concerns about how much growth there’s going to be unless they get a new product to kind of come in and take the place of their hepatitis C drug.
What’s interesting to me is that this is not only a cheap stock with a value score of 93, it’s also across the board pretty strong fundamentally.
Momentum is at 98. The company has had tremendous growth in recent periods and that growth is going to slow, but I still think it’s going to be positive.
Quality is 99. The company has an amazing track record and returns on investment and equity are quite high. Financial strength is 90. High margins, low debt. Earnings estimate is 87 out of 100 so the estimate trends are still pointing the right way.
The performance score is 44, which is below average. That’s not atypical for a stock that gets such a high value score. We are often a little bit dubious if a performance score is very low.
Below 20 is kind of a yellow flag for us, suggesting that Wall Street maybe sees something that Quadrix isn’t seeing, but Gilead Sciences is a good value in the biotech group—which is hard to find—and we have it as a focus list buy which is our top buy recommendation.
Steven Halpern: We’ve only got a minute left, but if you could just mention another name or two that our listeners could do a little research on?
Richard Moroney: Another stock that is more out of favor, but also quite cheap is Lam Research (LRCX). This company is a semiconductor equipment maker. There are concerns about an industry downturn and a drop-off in orders.
It may not be the most dynamic stock for the next couple months until some industry concerns get settled out, but the stock is quite cheap and has a very good track record. We have that stock ranked as a buy.
Steven Halpern: Again, our guest is Rich Moroney of Dow Theory Forecasts. Thank you so much for your time, today.
Richard Moroney: Sure. Thanks for having me.