The 5 Key Aspects of Analysis

The five key aspects of analysis:

• Financial Strength
• Profitability
• Growth
• Valuation
• Momentum

The Financial Strength Rank

The Financial Strength Rank is calculated using the following criteria:

• The higher the better:
  • Interest coverage ratio
  • Altman Z-Score
  • Equity-to-Asset ratio
  • Cash-to-Debt ratio
• The lower the better:
  • Debt-to-revenue ratio

Backtesting shows that the stocks of companies that have the worst financial strength ranks perform badly on average, but as long as the financial strength rank is above the 50th percentile, there is no significant difference in the stock performance based on the financial strength rank.

Therefore, in stock screening, we want to avoid those with poor financial strength ranks, but as long as the rank is 5 or above, it is acceptable.

The results of the median performance of each financial strength rank group in backtesting are shown below. The performance is calculated assuming:

1. The portfolio invests in all of the stocks in the same rank.
2. The portfolio is rebalanced once a year, on the first day of each year.
3. The holding period is 12 months.
4. The median value of all the stocks in the group is used for comparison.

There should be two charts here:

Chart 1: The relative performances of stocks with different ranks.

1. Query: “SELECT * FROM gurufocu_main.rank_gain where country='US' and rankby = '`rank_balancesheet`/10' and rank=$rank;” where $rank should be from 1 to 10.
2. The gain in the same year-month should be averaged
3. The relative performance for each rank is $gain[$yearmoth][$rank]-$average_gain[$yearmoth]
4. Draw Chart: Year-Month vs. Gain ($rank), there should be 10 lines

The chart is like this:

Chart 2: The cumulative gain performance of different ranks, use only the January number.

$cumulative_gain is calculated from the $gain[$year01][$rank]

The chart is like this:

The same needs be done for other ranking parameters. Replace '`rank_gf_value`' in the query in step 1 with these parameters

'`rank_profitability`/10',

'`rank_balancesheet`/10' ,

`rank_momentum`' ,

'`rank_growth`'

The Profitability Rank

The Profitability Rank is calculated using the following criteria:

• The higher, the better:
  • Mean operating margin (10-year mean average profit margin)
  • Operating margin growth
  • Piotroski F-Score
  • Business predictability rank
  • 5-year revenue growth
  • Number of years that were profitable within the last 10 years
  • 10-year median ROIC

GuruFocus found that the Profitability Rank and Growth Rank are the two most sensitive parameters among the five parameters we checked. The other three are the Financial Strength Rank, the Valuation Rank and the Momentum Rank. Over the long term, the companies with the highest Profitability Rank perform the best.

During market recoveries after a big crash, the most profitable companies may not perform as well as the beaten down low-quality companies, but the most profitable companies are much more resilient during market crashes.

The Growth Rank:

The Growth Rank is calculated using the following criteria:

• 5-year revenue growth rate, the higher, the better
• 3-year revenue growth rate, the higher, the better
• 5-year EBITDA growth rate, the higher, the better
• The predictability of 5-year revenue. The most consistent it is, the higher the rank.

GuruFocus found that the Profitability Rank and Growth Rank are the two most sensitive parameters among the five parameters we checked. The other three are the Financial Strength Rank, the Valuation Rank and the Momentum Rank. Over the long term, the companies with the highest Profitability Rank perform the best.

During market recoveries after a big crash, the most profitable companies may not perform as well as the beaten down low-quality companies, but the most profitable companies are much more resilient during market crashes.

Please note that we are using 5-year EBITDA growth rate as a parameter, so the company needs to at least have positive EBITDA during the past five years. The reason we use EBITDA instead of EPS is that with EBITDA we can rank a lot more companies, as a company may have positive EBITDA but negative EPS. Since we are looking at the growth here, EBITDA gives us a pretty clear picture about the growth in the business operations of the company.

The Valuation Rank:

The Valuation Rank is determined by the price-to-GuruFocus-Value (P/GF Value) ratio.

GuruFocus found that for valuation, we cannot simply give stocks a better Valuation Rank simply because they have a lower P/GF Value ratio. The backtesting shows that over the long term, the two worst-performing groups are the most expensive group (with the highest P/GF Value ratio) and the least expensive group (with the lowest P/GF Value ratio).

We can understand why the most expensive group underperforms. We were initially puzzled by the underperformance of the least expensive group, but as we realized,there is a reason why some stocks are super cheap. If they look too undervalued, it is often because the businesses behind them are poor quality. The market realized this and gave them low valuations. In a way, the market is efficient.

After multiple backtesting analyses, we have granted the stocks in the cheapest 30% the best Valuation Rank, as they have performed the best over a full market cycle.

Stock performance is actually not as sensitive to valuation as it is to growth and profitability. On average, the companies in the 20%-50% valuation groups have similar performances. Therefore, we should avoid the most expensive and the least expensive ones. We can be more tolerant on valuation.

The Momentum Rank

For the Momentum Rank, we considered the residual momentum concept that was widely studied academically, including by Blitz and his colleagues and by Nobel Prize laureate Fama and French. However, we did not find any significant difference in the performances of stocks with different ranks of residual momentum.

Therefore, we use traditional momentum instead. The Momentum Rank is determined using the standardized momentum ratio, which is the ratio of the average of the 12 month-1 month and 6 month-1 month performances, dividend by the beta of the stock over the past 12 months.

For momentum, we found similar results to valuation in terms of how well it correlated with stock price performance. That is, stock price performance does not have a monotonic correlation with the momentum ratio. The stocks with the highest momentum ratios perform worse than those at about the 70th percentile. Therefore, in the Momentum Rank, we ranked the stocks at about the 70th percentile of the momentum ratio as the highest, at Rank 10.

Total Score:

The Total Score is calculated based on the five key aspects of analysis:

• Financial strength
• Profitability
• Growth
• Valuation
• Momentum

Through backtesting, we know that each of these key aspects has a different impact on the stock price performances. Thus, they are weighted differently in calculating the Total Score. The Total Score is on a scale from 0 to 100, with 100 as the highest score.

The Profitability Rank and the Growth Rank are weighted fully. The other parameters have less weight. When we did the backtesting of the stocks in different ranges of Total Scores, we did find that those with the highest Total Score had the best performance.

Dividend Rank: (This has not been found to be related to the future stock performance, but you can mention dividends in these aspects.)

The parameters used in ranking:

1. Forward dividend yield, the higher, the better
2. Payout ratio, the lower, the better
3. Dividend growth rate (5 year), the higher, the better
4. Dividend start year, the earlier, the better.
5. For those that do not pay dividends, rank=1
6. For those that pay dividends, rank is between 6-10