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Ranking Stocks for Investment – First in Series

Our Ranking

Our proprietary investment analysis system is able to rank the 1200 companies I keep in our database according to several factors. These factors lead us to six ranks based upon traditional investment concepts: Earnings Growth, Financial Strength, Value, Momentum, Quality and Fundamentals. Each of the rankings combines several financial ratios that reflect each of the above investment concepts, and they are chosen based upon years of analysis that show that these specific ratios provide me with a clear picture of how the company fairs under each concept. They are ranked from 100 (best) to 1 (worst) on a relative basis to their industry and to the S&P 1500.

Quality Ranked Companies

Today, I thought we would look at our Quality Rank – one of the factors that lead to their being designated as High Quality or Low Quality. The other factors include having 9 of past 10 years as profitable, a Return on Invested Capital > Weighted Average Cost of Capital, Growing Book Value, growing earnings, bear market stock price performance, etc.

However, being either high or low quality in and of itself is not a reason to buy or sell a company – there are times in the market that High Quality companies under-perform Low Quality companies,and visa versa. No one set of ratios can tell you everything you need to know to buy or sell a company, but it gives you a place to start due diligence that gets you to the buy or sell decision.

Starting with our Quality Rank, this set of ratios gives me a feel for the soundness of a company’s financial position. The ratios I use are centered around four major items that comprise quality: Gross and Operating Margins; Asset Turnover; ROE and ROI; and Debt Management.

Below is a non-exhaustive list of companies from our database that are categorized as either High Quality or Low Quality.

QualityCompany NameBCNA Quality Rank3yr Avg Return
Low QualityAlaska Air Group Inc50.66%
Low QualityBank of America Corp17.115%
Low QualityCornerstone Building Brand42.8-1%
Low QualityChevron Corp18.4-1%
Low QualityFord Motor Co22.211%
Low QualityFifth Third Bancorp61.514%
Low QualityGeneral Electric Co18.71%
Low QualityJPMorgan Chase & Co49.818%
Low QualityTruist Financial Corp51.48%
Low QualityValero Energy Corp63.3-9%
Low QualityWESCO International Inc44.122%
Low QualityWells Fargo & Co26-2%
Low QualityExxon Mobil Corp38.4-5%
High QualityDollar General Corp91.432%
High QualityGenmab A/S99.737%
High QualityBarrick Gold Corp98.624%
High QualityKirkland Lake Gold Ltd99.933%
High QualityMercury General Corp92.914%
High QualityBoston Beer Co Inc59.561%
High QualitySouthern Copper Corp91.516%
High QualitySkyworks Solutions Inc79.820%
High QualityTaiwan Semiconductor86.947%
High QualityUnitedHealth Group Inc95.220%
High QualityVeeva Systems Inc71.453%
High QualityVertex Pharmaceuticals Inc99.811%

To get a feel for whether High Quality companies are a better investment than Low Quality companies, we can scan the list above and see that, by and large, the 3-year Average Return for High Quality Companies is much better than Low Quality Companies. But I thought we should be a bit more rigorous and look at a linear regression of each quality designation to see the magnitude of the difference.

This scatter plot makes it easy to see that the Blue Dots representing the High Quality companies are well above (i.e., higher three year average return) the Red Dots representing Low Quality companies. Again, let me restate this: Low Quality does not mean they are bad, it just mean that in the three most recent years the ratios that define them as Low Quality were not as high as other companies in their industry or in the S&P 1500.

Why Is This Important Now?

At some point, we will have a market correction that exceeds a simple 10% 0r 20% move down in price. With the Federal Reserve now beginning to talk about tightening money supply due to above target inflation, that could be a catalyst for such a correction (or even a bear market). As such, we want to have the best companies in client portfolios that can withstand a major draw down when the inevitable happens down the road.

The Investment Strategy

In the normal course of portfolio management during this period in time where we have been warned that monetary tightening is in the plans, we want to book the gains on the companies that show the least ability to withstand a bear market and focus on the companies that have the best ability to withstand a bear market. We do not want to see the gains we have made be lost by not monetizing them when the market tells us it is time.

What’s Next?

Our next discussion will be on our Earnings Growth Rank – the original analytical system whose nexus started with my Masters Thesis that set out to disprove the Efficient Market Hypothesis (yes, that is how long ago it was – it has graduated to a Theory and is no longer a Hypothesis). The synopsis of the thesis was that in spite of the strong support for the Hypothesis, there really are certain financial ratios in the public realm that when viewed as a whole can provide index beating returns over the long run. And given our track record of beating the index over the long run, the Earnings Growth Rank is a very important part of our investment process.


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