Part 1: Overview
The purpose of the Stock Types is to group companies according to the underlying fundamentals of their business. They answer the question: If I buy this stock, what kind of company am I buying? Unlike the style box, the emphasis with the Stock Types is on income statement, balance sheet, and cash-flow data—not price data or valuation multiples. We focus on the company, not the stock.
Investors can use the Stock Types to diversify portfolios across a variety of different kinds of companies. They can also use the Stock Types as a benchmark for comparing the performance of any one company against the performance of similar companies. Finally, in analyzing companies in different Stock Types, different questions become important. For Cyclicals, how did the company do during the last recession. For High Yield, how dependable is the company’s dividend? For Speculative Growth, how much cash is the company having to spend to generate its rapid revenue growth?
We divide the universe into eight Stock Types. There’s nothing magical about eight; we simply broke out companies the way we tend to think about them when analyzing them. (There are some stocks that don’t have enough data to assign a Stock Type. These are labeled N/A.) Also, a stock may meet the conditions for more than one Stock Type. We designed the algorithm, however, so that it will assign only one Stock Type per stock—the Stock Type we feel is most appropriate.
The eight Stock Types are:
Distressed
Companies that are having serious operating problems. This could mean declining cash flow, negative earnings, high debt, or some combination of these. Such "turnaround stocks tend to be highly risky, but also harbor some intriguing investments.
High Yield
Companies whose stocks offer a high dividend yield. These tend to be mature companies that choose not to reinvest the bulk of their earnings. For investors interested in income, this is where to look.
Hard Asset
Companies whose main business revolves around the ownership or exploitation of hard assets like real estate, metals, timber, etc. Such companies typically sport a low correlation with the overall stock market, and have traditionally been where investors look for inflation hedges.
Cyclicals
Companies whose core business can be expected to fluctuate in line with the overall economy. In a booming economy such companies will look excellent; in a recession, their growth stalls and they might even lose money.
Speculative Growth
Companies whose sales have grown very rapidly over the trailing five-year period, but whose earnings growth has been spotty. These tend to be companies in the early phase of their growth cycle.
Aggressive Growth
Companies whose sales and earnings have grown very rapidly over the trailing five-year period. These firms tend to be a step up the quality ladder from speculative-growth firms.
Classic Growth
Companies that show moderate to rapid growth over the trailing five-year period in two of the following three categories: sales, earnings, dividends. These tend to be fairly mature firms, but ones that are still generating steady growth.
Slow Growth
Companies that have grown slowly, if at all, over the trailing five-year period. These companies tend to be mature firms.
Part 2: Methodology
To assign Stock Types to each stock, we run our stock database through a filter program. This filter program assigns the stock to the most appropriate Stock Type. A stock may meet the criteria for more than one Stock Type, but the algorithm was designed to assign the stock to the most suitable Stock Type.
First, the program checks to see if the stock qualifies for any of the first four Stock Types: Distressed, High Yield, Hard Asset, and Cyclical. Each of these Stock Types is pretty clearly defined. Plus, because they focus on basic investment categories, these four categories should take precedence over the final four, which focus more on determining how fast a company is growing and how mature its business is. It’s more important, for example, to tell people a stock is Distressed than that it falls into Speculative Growth.
Distressed
We first check to see if the company meets any of our criteria for Distressed. The reason this Stock Type is first: It’s the one most important to alert people to. We assign a Stock Type of Distressed if any of the following six conditions are met:
Declining cash flow and negative earnings. Studies have shown declining cash flow to be one of the best predictors of bankruptcy. By coupling falling cash flow and negative earnings, we capture companies sliding into deep trouble.
total cash flow year 1 < total cash flow year 2 < total cash flow year 3
AND
EPS TTM < 0
AND
Two or more of the following are less than 0: EPS quarter 1, EPS quarter 2, EPS quarter 3, EPS quarter 4. (This final condition is to make sure it isn’t just one abnormal quarter—caused by a big one-time charge, for example—that is causing earnings to be negative.)
Declining revenues and negative earnings. Declining revenues is usually a sign that a company’s having trouble selling its goods. Coupled with consistently negative earnings, it signals a company in trouble.
Revenue 1 < revenue 2 < revenue 3
AND
EPS TTM, EPS 1, and EPS 2 < 0
Declining revenues, negative earnings, and falling or negative cash flow.
Revenue 1 < revenue 2 < revenue 3
AND
Three or more of the following are negative: EPS quarter 1, EPS quarter 2, EPS quarter 3, EPS quarter 4
AND
Cash flow growth year 1/year 2 < 0 OR NMF (Note: the NMF captures companies with negative cash flow in year 1)
High debt and low debt coverage. Companies with abnormally high debt levels run the risk of going bankrupt with the slightest downturn in business. We look at both the debt level of the company, and whether the company is generating enough cash flow to pay the interest on the debt.
Long-term debt/market cap (?) > 0.7
AND
Total cash flow 1/long-term debt quarter 1 < 0.05
AND
Total cash flow 2/long-term debt quarter 1 < 0.05
tiny price/book ratio. This criterion plucks out stocks whose valuation has collapsed to a level that’s just a tiny fraction of what a healthy company would trade for.
Price/book < (5% of average large-cap price/book ratio)
Auditor has qualified opinion OR the company is in bankruptcy
Note: We exclude very rapidly growing companies from Distressed, since these are typically young companies more appropriately classed below under Speculative Growth. Specifically, we exclude companies whose revenue growth is greater than 50% for each of the following three periods: quarter1/quarter5, quarter2/quarter6, and year1/year2.
High Yield
We next check all the remaining stocks for those with dividend yields greater than two times the average for large-cap stocks. We exclude limited partnerships and REITs, since these stocks by law pay out all or most of their earnings as dividends (and thus naturally tend to have high dividend yields). We’re looking for regular stocks that offer a nice dividend yield. We also exclude stocks that would qualify for the Hard Asset Stock Type, since people are probably interested in them more for their hard asset quality than their high yield quality.
Hard Asset
We check the remaining stocks to see if they fall into one of the following industries, as defined by the government’s SIC Codes: precious metals, oil & gas, REITs, and other real-estate companies. These companies can be expected to move in tandem with hard-asset prices (and have a correspondingly below-average correlation with the overall stock market), making them attractive diversification tools and inflation hedges.
Cyclical
We check the remaining stocks for companies in either the Industrial Cyclical or the Consumer Durable Morningstar Stock Sector. These are companies whose profits are likely to be highly influenced by the overall direction of the economy.
Once we’ve assigned companies into these four Stock Types, we take the remaining companies and see which of four "growth types they fit into. Because any one company can fall into two or more different growth Stock Types, and because the lines between different growth types are arbitrary, we use a "scoring system to categorize stocks. We list several criteria for each of the four Stock Types, and count up what percentage of those criteria each company meets. We then assign a stock to the Stock Type for which it meets the highest percentage of criteria. For example, suppose a company meets 10% of the Slow Growth criteria, 33% of the Aggressive Growth criteria, and 50% of the Classic Growth criteria. We assign this stock to Classic Growth.
We feel a scoring system greatly lessons potential flaws in categorizing companies according to historical financial information, particularly historical growth rates:
First, many companies don’t have meaningful growth rates for all years. By using multiple criteria for each growth type, we can pick up enough meaningful years to classify a company.
Second, since the line separating one growth type from another is fuzzy (to say the least!), the more data points we use the more confidence we have that we’re actually pinning the company in the intuitively "correct type.
Third, by using a scoring system, it’s okay for the conditions of the various growth types to overlap. A stock will still land in the Stock Type in which it most naturally belongs. This means that the arbitrary nature of the cut-offs we use becomes less of a problem. By using many data points, we don’t have to worry that any one cut-off is determining the Stock Type of the company.
Note also that we always use some multiple of five-year average GDP growth as the benchmark by which we assess a company’s growth, instead of a fixed percentage change. We do this for two reasons: 1) The growth rates of most companies will fluctuate with a country’s GDP growth, so that what looks like a slow-growing company may actually be growing several times faster than the overall economy, and 2) since GDP includes inflation, our algorithm won’t be unduly warped by rapid inflation, which would make companies appear to be growing faster than they really are.
One more thing: The reason for all the different criteria is that without them, a lot of companies get misclassified (because of one abnormal year that throws the growth rates out of kilter) or receive no classification (because we can’t calculate a growth rate for certain years). The criteria for each of the four "growth types is as follows.
Speculative Growth
We have eight criteria that screen for companies with rapid revenue growth (more than four times GDP growth) but slower, or nonexistant, earnings growth. So if a company meets six of these eight criteria, it receives a Speculative Growth score of 6/8, or 75%. The eight criteria are:
1)
Annualized revenue growth between year1/year5 greater than 4*GDP Growth
AND
(Earnings growth over same period less than 3*GDP Growth
OR
Three or more "bad years between year 1 and year 5)
Note: A "bad year is one in which either earnings are negative, or for which earnings growth is negative. Companies with many such bad years often have earnings growth rates that are not meaningful. (This problem is especially thorny for Speculative Growth firms, which by definition are those with spotty earnings.) We created the bad year concept so we could evaluate these companies within the framework of the Stock Type algorithm.
2)
Annualized revenue growth between year1/year4 greater than 4*GDP Growth
AND
(Earnings growth over same period less than 3*GDP Growth
OR
Two or more "bad years between year 1 and year 4)
3)
Annualized revenue growth between year1/year3 greater than 4*GDP Growth
AND
(Earnings growth over same period less than 3*GDP Growth
OR
Two or more "bad years between year 1 and year 3)
4)
Annualized revenue growth between year1/year2 greater than 4*GDP Growth
AND
(Earnings growth over same period less than 3*GDP Growth
OR
One "bad year between year 1 and year 2)
For the final four criteria, we repeat the process, but this time looking for a drop in earnings over the relevant period. This way, even if earnings are negative in year 1 or in any of the preceeding years, we can still make comparisons (whereas growth rates become NMF if there’s a negative earnings year):
5)
Annualized revenue growth between year1/year5 greater than 4*GDP Growth
AND
Earnings year 1 < earnings year 5
6)
Annualized revenue growth between year1/year4 greater than 4*GDP Growth
AND
Earnings year 1 < earnings year 4
7)
Annualized revenue growth between year1/year3 greater than 4*GDP Growth
AND
Earnings year 1 < earnings year 3
8)
Annualized revenue growth between year1/year2 greater than 4*GDP Growth
AND
Earnings year 1 < earnings year 2
Note: In each of the above criteria—and for the criteria in the following Stock Types—we also use revenue and earnings growth figures based on TTM figures. For example, in addition to looking at growth between year 1 and year 5, we’ll also look at growth between TTM and year 5. That way, companies with abnormal or unavailable year 1 information can still meet any of the above criteria if there is a valid TTM figure available. The best example is a company with a big loss in year 1, which makes earnings growth impossible to calculate based on year 1; if the loss was the result of a big charge in a single quarter, however, there might be a useable TTM figure available.
Also, if earnings per share growth is unavailable for a given company, we use net income growth. This also applies to the following three Stock Types.
Aggressive Growth
We have nine criteria for Aggressive Growth. We’re looking for companies with rapid sales (greater than four times GDP growth) and rapid earnings growth (greater than four times GDP growth). The nine criteria below are divided into three groups of three.
1-3)
Annualized revenue growth year1/year5 > 4*GDP Growth
AND
One of the following:
Earnings growth year1/year5 > 4*GDP Growth
Earnings growth year1/year4 > 4*GDP Growth
Earnings growth year1/year3 > 4*GDP Growth
4-6)
Annualized revenue growth year1/year4 > 4*GDP Growth
AND
One of the following:
Earnings growth year1/year5 > 4*GDP Growth
Earnings growth year1/year4 > 4*GDP Growth
Earnings growth year1/year3 > 4*GDP Growth
7-9)
Annualized revenue growth year1/year3 > 4*GDP Growth
AND
One of the following:
Earnings growth year1/year5 > 4*GDP Growth
Earnings growth year1/year4 > 4*GDP Growth
Earnings growth year1/year3 > 4*GDP Growth
Note: As for Speculative Growth, we also use TTM figures in each line of the above criteria.
Classic Growth
There are a total of 16 criteria for Classic Growth. We first look for good earnings growth (between one and five times GDP growth) over the long term (at least three years) and either good dividend growth (greater than GDP growth) over the trailing five years OR a reasonably high dividend yield (between ½ and 2 times the average for large caps):
1)
GDP Growth < Annualized earnings growth year1/year5 < 5*GDP Growth
AND
(Annualized dividend growth year1/year5 >= GDP Growth
OR
Dividend Yield between ½ and two times the average dividend yield for large caps)
2)
GDP Growth < Annualized earnings growth year1/year4 < 5*GDP Growth
AND
(Annualized dividend growth year1/year5 >= GDP Growth
OR
Dividend Yield between ½ and two times the average dividend yield for large caps)
3)
GDP Growth < Annualized earnings growth year1/year3 < 5*GDP Growth
AND
(Annualized dividend growth year1/year5 >= GDP Growth
OR
Dividend Yield between ½ and two times the average dividend yield for large caps)
The next nine criteria (broken out here into three groups of three) screen for good revenue growth and good earnings growth:
4-6)
GDP Growth < Annualized revenue growth year1/year5 < 4*GDP Growth
OR
One of the following:
1.5*GDP Growth < Annualized earnings growth year1/year5 < 5*GDP Growth
1.5*GDP Growth < Annualized earnings growth year1/year4 < 5*GDP Growth
1.5*GDP Growth < Annualized earnings growth year1/year3 < 5*GDP Growth
7-9)
GDP Growth < Annualized revenue growth year1/year4 < 4*GDP Growth
OR
One of the following:
1.5*GDP Growth < Annualized earnings growth year1/year5 < 5*GDP Growth
1.5*GDP Growth < Annualized earnings growth year1/year4 < 5*GDP Growth
1.5*GDP Growth < Annualized earnings growth year1/year3 < 5*GDP Growth
10-12)
GDP Growth < Annualized revenue growth year1/year3 < 4*GDP Growth
OR
One of the following:
1.5*GDP Growth < Annualized earnings growth year1/year5 < 5*GDP Growth
1.5*GDP Growth < Annualized earnings growth year1/year4 < 5*GDP Growth
1.5*GDP Growth < Annualized earnings growth year1/year3 < 5*GDP Growth
The final three criteria screen for good revenue growth over the long term (at least three years) and either good dividend growth over the trailing five years OR a reasonably high dividend yield:
13)
GDP Growth < Annualized revenue growth year1/year5 < 4*GDP Growth
AND
(Annualized dividend growth year1/year5 >= GDP Growth
OR
Dividend Yield between ½ and two times the average dividend yield for large caps)
14)
GDP Growth < Annualized revenue growth year1/year4 < 4*GDP Growth
AND
(Annualized dividend growth year1/year5 >= GDP Growth
OR
Dividend Yield between ½ and two times the average dividend yield for large caps)
15)
GDP Growth < Annualized revenue growth year1/year3 < 4*GDP Growth
AND
(Annualized dividend growth year1/year5 >= GDP Growth
OR
Dividend Yield between ½ and two times the average dividend yield for large caps)
Slow Growth
There are 10 criteria for slow growth. We’re looking for companies with slow revenue growth (less than GDP growth) and slow earnings growth (less than two times GDP growth):
1-3)
Annualized revenue growth year1/year5 < GDP Growth
OR
One of the following:
Annualized earnings growth year1/year5 < 2*GDP Growth
Annualized earnings growth year1/year4 < 2*GDP Growth
Annualized earnings growth year1/year3 < 2*GDP Growth
4-6)
Annualized revenue growth year1/year4 < GDP Growth
OR
One of the following:
Annualized earnings growth year1/year5 < 2*GDP Growth
Annualized earnings growth year1/year4 < 2*GDP Growth
Annualized earnings growth year1/year3 < 2*GDP Growth
7-9)
Annualized revenue growth year1/year3 < GDP Growth
OR
One of the following:
Annualized earnings growth year1/year5 < 2*GDP Growth
Annualized earnings growth year1/year4 < 2*GDP Growth
Annualized earnings growth year1/year3 < 2*GDP Growth
10)
Average of (revenue growth year1/year5) and (revenue growth year1/year 4) < GDP Growth
This last criterion is meant to capture slow-growth companies for which earnings growth is unavailable or abnormal.
Final Notes
One group of companies we do not run through this scoring system—those that meet the following three conditions:
have recently had an IPO,
whose revenue is less than $5 million, and
whose 1-year revenue growth is greater than 4*GDP growth.
We always stick these companies in Speculative Growth. Since these are young companies without a lot of historical data, and because their growth makes them a natural fit for Speculative Growth, we simply stick them in this Stock Type automatically.
All growth rates used in the Stock Type algorithm are annualized.