Forsythe - Schwab Equity Ratings

GREG FORSYTHE HAS never bought a lottery ticket, at the store or in the stock market. And that points to a key element in the successful Schwab Equity Ratings system. "I won't play any game seriously that I don't have a forecast advantage in," says Forsythe, the creator and director of the team behind the quantitative stock-selection method, which has fueled the discount broker's long-term success in Barron's rankings of brokers' top stock picks ("Who's the World Champ?" Sept. 25). Since 2003, the model portfolios of Charles Schwab (SCHW1) have dominated the long-term rankings compiled by Zacks Investment Research, which compares the focus lists of about a dozen major Wall Street brokerages. Schwab has been first in either the three- or five-year period in each ranking, except one, when it finished second over three years. Wall Street's army of sell-side analysts, who create the more traditional focus lists, are good at picking great companies, but aren't necessarily consistent at picking great stocks over time, says Forsythe, who works in Chicago. In its quest for stocks with sustainable high earnings growth, the Street focuses on profits. "The payoff from accurate earnings forecasting is extremely high," he says, but the accuracy is typically too low to pay off. Just 15% of quarterly EPS forecasts are within 1% of actual reported EPS, according to a Schwab study. In traditional analysis, there also seems to be an under-appreciation of the forces of creative destruction. "Analysts study the company, the industry, the management and forecast earnings," he says. The implicit assumption is "if I find a great company, I'll find a great stock....But if a company is great today, it doesn't necessarily mean it's going to be great in the future, and that's where this fails," Forsythe continues." Great companies get big and hard to operate; saturate their markets. Success attracts competition." Because analysts and investors usually extrapolate success far into the future, the great companies of today tend to be overvalued, he maintains. "You have got to look at the expectations imbedded in the stock price. You can get the fundamentals right, but you may not get the stock right." The issue isn't which stocks have the strongest fundamentals, but which stocks are offered at prices that don't reflect their actual chance of success. There are strong parallels, he adds, between the Schwab Equity Ratings system (SER) and Sabermetrics, a statistical approach to evaluating baseball players and strategies described in Michael M. Lewis' book Moneyball. In a way, the typical focus list is comparable to the collected wisdom of baseball managers and scouts looking at batting averages and runs batted in. While SER's statistical analysis of less widely followed company financial data, like the relationship between income and cash flow and 17 other factors, is similar to Sabermetrics' emphasis on factors like on-base percentage. Making the Grade: The Schwab Equity Rating system ranks 3,200 stocks weekly on 18 factors the firm says are correlated with future returns. Forsythe points to a study his team did of Wall Street earnings projections and stock recommendations, as compiled by Zacks. From 1995 through 2004, the stocks with the lowest earnings- growth forecasts and worst ratings beat those with the highest. Street analysts are capable, says Forsythe, but it's a "perverse" capability. "You are better off doing the opposite of what they do. I am not saying these aren't smart people. My explanation is a misplaced research focus," he says. He also maintains that investors and analysts are too focused on the payoff. Discovering the biotech firm that finds the cure for cancer would produce a high reward, but the probability of hitting the big one is very low, says Forsythe, who notes: "The biotech industry has destroyed about 60% of the capital that's ever been put to work in the industry." The payoff from a few winners has been swamped by losses from the many failures. Profit estimates aren't part of the SER model — a "very big distinction" between it and the conventional Street approach and even other quantitative methods, many of which employ analysts' forecasts. (Directional changes in consensus earnings forecasts, however, are used in SER.) What the Schwab method looks for is "surprise," which can be defined a lot more broadly than earnings. Indeed, nothing is more highly correlated with stock returns than knowing which companies are going to report the most positive and most negative earnings surprises one year from now, says Forsythe. If Google, a current market favorite, meets its expected growth rate of 40% a year, its stock isn't going to go up 40% annually, he argues, but rather 10%-15% because the 40% assumption is already in the price. It's more important to know not what Google is going to make next year, but whether it earns more or less than what people think it will, he says. (By the way, Google is rated C, or Hold, by SER, whose highest rating is A.) "How do you search for factors correlated with surprise?" asks Forsythe, who comes to the investment world with an unlikely background. He was trained as an industrial process engineer at Purdue and worked at Union Carbide before obtaining an MBA at night from the University of Chicago. "My father-in-law introduced me to stocks. I noticed one stock worked, one didn't. It was too random and that's when the engineer in me kicked in," says Forsythe. "I wanted to become a better investor." Free cash flow (net income plus depreciation and minus capital expenditures and dividends) is "very, very important," the biggest single driver behind the SER ratings, compiled from the 18 factors. These are weighted differently and grouped among four categories: fundamentals — the most important component at 50% of the grade — valuation and momentum, each 20%, and risk, 10%. The Schwab Equity Rating model ranks 3,200 companies weekly on each factor and against one another. Letter grades are then assigned to each stock. Credibility Gap: A study of stock performance from 1995 through 2004 showed that shares top-rated by Wall Street analysts underperformed those that were out of favor and had low earnings-per-share growth estimates. SER focuses on the quarterly cash flow statement, which many analysts neglect because they "obsess" on earnings, Forsythe says. "What people ignore is less likely to be built into expectations, that's why we spend so much time with that statement," he offers. Among other things, SER compares inventories to sales, that is, a balance-sheet account to an income account. Traditional analysis loves high profit margins and strong returns on equity, but Forsythe says the former has zero correlation to stock returns and the latter just "some value." In fact, "the ratio of free cash flow to equity gives you more insight into future stock returns," he says. SER also compares rates of change: How fast are sales growing versus assets, inventories and receivables, for example? If sales rise 15% annually while assets grow 10%, it means the company is improving asset utilization and becoming more efficient. These are "excellent indicators of returns and surprises," he says. Another important element is cash. "We've found that generally [stocks of] companies that have a lot of cash, relative to their market value, perform well." Some argue that a high cash level means that management doesn't know what to do with it, "but that's not what the data tell us," Forsythe says. Why? Well, unless it's an IPO, "if you have a lot of cash you've probably been earning it...and that's a good thing." But the greater the capital expenditures to asset ratios, the lower the subsequent stock returns, according to SER. It could be managers often make bad capital investments, or it also could be that capital-intensive businesses generate lower returns in the long run. But, in Forsythe's view, the history is "very, very convincing" that the higher the capex rate, the lower the rate of return over time. Stock buybacks (netted against issuance) are one more SER factor and historically a signal that the company feels the stock is undervalued. "However, these days, everyone is buying back stock and that can't be good, so our model will have to evolve," Forsythe adds. Short-selling is an element that the Schwab system also considers; one that Forsythe refers to as the "smart money," whereas "dumb money historically has been the analysts' recommendations. We've found short sellers are somebody you want to watch." He looks at both the level and direction of short sales. Are the number of short sales rising or are the shorts covering? "We've found that is predictive of future returns," he adds. Among the major factors, momentum has a shorter time horizon. Here, SER looks at things like the direction of analyst ratings and profit forecasts, as well as price momentum. Stocks' past changes don't predict future price changes at the tick level but, long term, price change does tend to continue. "If investors are buying a stock, driving up its price, that's saying that expectations on that company are improving and they tend to move in trends that we can pick up." The last component is risk, which covers the market capitalization and stability of things like revenues. "Measurements here tend to get us in less volatile stocks, which most investors prefer," Forsythe says. No system is perfect, of course. As Forsythe readily acknowledges, "not every A outperforms, not every F underperforms," which is why Schwab's equity model includes 100 stocks. Additionally, there are aberrations that distort performance, like the classic biotech IPO that hits it big. Most times, such companies will be rated Fs after they go public. "One is going to hit. The nice thing is if you are right 99 times and wrong once, you are right on average." The Schwab Equity Ratings system encounters limitations when everyone in the market is thinking one way, such as at the end of a deeply bearish period or frenzied bull market. In late 2002 to early 2003, when the market embraced risk and poor-quality stocks, the Fs outpaced the As and Bs. But, eventually, people began paying attention to quality. While there are a few things in the model no one else probably looks at, "the combination is the unique thing. It's not magic," he says. In his childhood, Forsythe's pals called him: "Hey, Foresight." The success of Schwab's model portfolio over a half-decade seems to justify the nickname.