Stock Picking Shortcuts

Investors can be entranced by “hot new investment strategies” and “shortcuts to beat the market.” Often, such rankings are also based on limited amounts of data, such as the level or consistency of historic growth rates in sales or earnings, or the level of projected earnings growth.

To analyze the predictive capacity of some of these stock-picking shortcuts, we looked at the largest 1,600 U.S. companies by market capitalization over the past 15 years. No silver bullet emerged.

• Forecasts fall flat. Stocks with the highest long-term earnings-per-share growth forecasts underperformed stocks with the lowest earnings-per-share forecasts by over 5% per year.

• History isn’t always prologue. Stocks with the highest five-year historic earnings-per-share growth rates performed no better than stocks with the lowest five-year historic growth rates. The same was true for historic sales-per-share growth rates.

• Stability can be overrated. Stocks with the most stable five-year earnings-per-share growth rates performed about the same as stocks with the most volatile trend lines. The same pattern held for sales-per-share growth rates.

• Even combos fall short. Combination strategies using sales and earnings growth rates, forecasts or stability measures showed no consistent predictive power.

There are two big problems with these shortcuts: They encourage the tendency of individual investors to project long-term trends while ignoring recent events, and most of the data is already accounted for in the prices of the stocks.

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To develop a better stock selection power ranking, investors need to look beyond easy-to-compute growth rate measures and forecasts that are known to everyone else. They need to dig deeper using more inputs to analyze how that growth was and is being achieved in order to get a more accurate view (versus the consensus) of what that growth is likely to be. Sound complicated? It is. That’s why Schwab came up with its Schwab Equity Ratings to do the homework for you, and to help investors focus on what we believe is important: long-term capital appreciation—not expected or historic earnings growth at any price.

Overall, Schwab Equity Ratings favor healthy companies that are expected to deliver positive earnings surprises not anticipated by the consensus of Wall Street analysts. That means A-rated stocks favor companies exhibiting a stable growth pattern, and we expect them, on average, to keep growing beyond consensus expectations.

By Brian Burda
CFA, Vice President, Schwab Equity Ratings®
Schwab Center for Investment Research®