Some Light 4th of July Reading?

Here at Northwest Investment Counselors, unlike many other investment managers, we maintain a spreadsheet on the S&P 500 which includes key fundamental data on every member of the index to assist us in identify attractive investments for both the Blue Chip Growth and Equity Income strategies. With the second quarter having just ended, we thought we would share some insights. To compile our data, we review every annual SEC 10-K filing for companies in the S&P 500. From this, we develop two of the three factors used in our valuation model; the third factor, sentiment, is compiled from data not contained in 10-K filings. The goal of using this data in our research process is to make sure we are fishing for investment ideas for clients in the most attractive parts of the market based on quality and value. Keep in mind that this is just one of the research tools we use for clients in our disciplined equity investment process.

We split the results into quintiles, or groupings of 100 stocks, with quintile 1 being the most attractive and quintile 5 the least attractive. The first chart below displays the average stock price returns (no dividends) for the value factors (blue bars) we use and the average stock price return for the S&P 500 (red bar) both for the second quarter. The rankings are calculated from data at the beginning of the quarter and then price performance is graphed over the following quarter. We repeat this process every quarter.

There isn’t enough room in this blog post to detail the formulae and all of the data adjustments, but suffice it to say that the value factor represents the price of a stock divided by the income it generates (price/income)–lower being ranked higher. There was a strong value component to what performed well in the second quarter and what did not (See Chart 1. Value Rank). The red bar shows that the average S&P 500 stock return during the second quarter was a little over 3%. Don’t confuse this with the return on the S&P 500 you may read about in the paper as that performance number is weighted by the market capitalization of the members of the S&P 500; it can and generally will be different. The first blue bar shows that the average stock return for the second quarter for the top 100 companies (first quintile) in the S&P 500 ranked according to our value factor at the beginning of the quarter was about 7.5%. The other quintiles either equaled the return of the S&P 500 (second quintile) or fell well short (quintiles four and five). The goal of this factor is to weed out glamour stocks (those that are most expensive) and focus on reasonably priced investment ideas.

Value Rank

Chart 1. Value Rank

Chart 2 below displays the quintile average stock performance for the quality rank (blue bars) compared to the S&P 500 (red bars)–again, the stock performance is for the second quarter for rankings at the beginning of the quarter.  Our quality rank, to summarize, captures the ability of a company to efficiently use their capital to generate a return for stockholders.  The top three quintiles (300 stocks) all exceeded the S&P 500 average stock return in the second quarter, while the poorest (quintile five) came up well short.  The goal of this factor is to weed out poor industries or poorly managed companies.

Quality Rank

Chart 2. Quality Rank

For the sake of brevity, we will skip the details on the sentiment rank for this blog post.  Overall, we equally weight the value, quality, and sentiment ranks to create our Quantitative Value (QV) summary statistic, which is displayed in Chart 3 below by quintile (blue bars) compared to the S&P 500 (red bar).  There was a solid relationship between the rank at the beginning of the quarter and the subsequent performance over the second quarter (just what we want to see).

QV Rank

Chart 3. Quantitative Value Rank

Our Quantitative Value strategy is composed of 50 stocks from the top quintile (top 100) while candidates for inclusion in the Blue Chip Growth and Equity Income strategies receive further scrutiny by our analysts since our target investment horizon is many years for Blue Chip Growth and Equity Income (plus an attractive dividend yield), not just the subsequent quarter.