Using Ratios To Identify Stocks Set To Outperform Their Peers: Introducing My Research

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Includes: ABBV, AMZN, ANDV, BAC, BUD, C, COST, DEO, FEYE, FTNT, GILD, GS, HD, HEINY, JNJ, JNPR, JPM, MPC, MRK, PANW, PFE, RDS.A, S, STZ, SYMC, T, TAP, TGT, TMUS, USM, VLO, VZ, WFC, WMT, XOM
by: Stock Scrutiny

Summary

Introducing the set of ratios I use in my system to identify the best fundamental companies.

I'll go over the process of ranking companies and how it contributes to their cumulative score.

The previous year's performance of this strategy will be presented as well as how I plan on moving forward.

Intro

I've been fascinated with ratios and their ability to capture certain aspects of a business in just one number for quite a while. Sure, ratios use historical data and thus don't predict future performance, but they can give key insights as to how well a company is running. On this note, I believe identifying companies with stellar growth records, a profitable business model, and maximum efficiency will set an investor up for success- and ratios are a useful way to do this. This leads me to introduce a system I constructed a little over a year ago that analyzes over 20 ratios and places them into 4 different categories: debt/solvency, profitability, efficiency, and growth. In the debt/solvency category, I placed the Current Ratio, Quick Ratio, Current Liquidity Ratio, Defense Interval, Interest Coverage Ratio, and Debt/Equity. These ratios cover a wide range of areas in companies' financial statements that are all related to debt in some way. Moving on, the profitability category is rich in margins, such as the Gross Margin, Operating Margin, and Net Margin, accompanied by other ratios such as Return on Assets, Effective Tax Rate, and Profit Per Employee. I believe each of these ratios effectively encapsulates a firm's profit-making abilities as much as possible without throwing in endless amounts of other ratios. Next, in the efficiency category, I utilized Asset Turnover, Return on Invested Capital, Return on Equity, Employee Cost Per Unit of Revenue, Sales Revenue Per Employee, and Capital Expenditure Ratio, all of which hit on different facets of what defines an efficient company. Finally, there is the growth category. In this category, I don't look at ratios, rather, I look at growth in Free Cash Flow, Revenue, Earnings Per Share, Total Debt, and Working Capital. Any company that shows solid growth in these areas (or lack thereof in the case of debt) is by no means certain to have a successful future, but in my opinion, is set to outperform their peers in the long run.

The Setup

Now that you know which metrics are used in my system, I'll now introduce how I set up and carry out my analysis. Before any calculations are done, I select an industry I want to focus on and pick 5 of the most prominent players. I try to stay in the same sector/industry because business models between, say, healthcare and retail, aren't similar enough for a comparison of ratios to be of any value. With these 5 selected companies, I find values of the previously mentioned ratios. At the end of this research, I have a table that looks like this:

Debt

XOM

VLO

ANDV

MPC

RDS.A

Current Ratio

.81 (5)

2.01 (2)

2.05 (1)

1.61 (3)

1.21 (4)

Quick Ratio

.53 (5)

1.25 (1)

1.19 (2)

.82 (4)

.90 (3)

Current Liquidity Ratio

727 (4)

265 (2)

72 (1)

573 (3)

974 (5)

Defense Interval

8.23 (4)

21.51 (3)

53 (1)

6.09 (5)

32.82 (2)

Interest Coverage Ratio

24.29 (1)

7.15 (2)

4.94 (4)

4.73 (5)

5.06 (3)

Debt/Equity Ratio

.25 (1)

.43 (2)

1.21 (5)

.96 (4)

.48 (3)

For this example, I chose my analysis on major oil companies. This table shows the values for only the debt ratios. It's important to note my analysis does this same process three more times with the profitability, efficiency, and growth ratios. Looking back at the table, you may notice the numbers 1-5 next to each ratio value. These numbers represent the company's respective place among its peers in regards to that ratio. Taking a look at Valero, we can see that it comes in 2nd place out of 5 when looking at their Current Ratio. 1st place out of 5 when looking at its Quick Ratio, and so on. Once all places are determined, I then find the average place of each selected company out of the 5 within the industry I looked at. To help further illustrate my point, I'll show the math behind it:

XOM- (5 + 5 + 4 + 4 + 1 + 1) / 6 = 3.33
VLO- (2 + 1 + 2 + 3 + 2 + 2) / 6 = 2
TSO- (1 + 2 + 1 + 1 + 4 + 5) / 6 = 2.33
MPC- (3 + 4 + 3 + 5 + 5 + 4) / 6 = 4
RDS.A - (4 + 3 + 5 + 2 + 3 + 3) / 6 = 3.33

The results seem to lean in favor of Valero, who finished the Debt section of my analysis with an average place of 2. The worst performer was Marathon, who averaged a place of 4. These numbers tell me, compared to its competition, Valero is in a much more manageable debt position. The opposite is true for Marathon. I then did this exact process to complete the profitability, efficiency, and growth parts of my analysis. In the end, I'm left with 4 scores for each of the 5 companies showing their average place regarding ratios of debt, profitability, efficiency, and growth. The table below shows these scores for each company.

Debt Score Profitability Score Efficiency Score Growth Score
Exxon Mobil 3.33 2.67 4.17 3.8
Valero 2 2.67 1.5 1.6
Tesoro/Andeavor 2.33 2.5 1.83 2.6
Marathon Petroleum 4 3.5 2.67 2.4
Royal Dutch Shell 3.33 3.67 4.83 4.6

With the final four scores, I calculate average cumulative score for each company, which looks as follows:

1. Valero- 1.94
2. Tesoro- 2.32
3. Marathon- 3.14
4. Exxon- 3.49
5. Royal Dutch Shell- 4.11

With these final numbers, each company has a final score with their debt, profit, efficiency, and growth situations taken into account. It's then easy to place the stocks in order from the lowest score (the lower the better) to the highest. In my example, Valero beats its competitors with a final score of 1.94 while Royal Dutch Shell lags behind at a dismal 4.11. In the next section, I'll try to help readers understand what I think these "scores" represent.

The End Goal

What I aim to find out, in short, is if a stock with a better score will outperform its peers in the long run who sport worse (higher) scores. My focus is the long run for one main reason: I think most can agree that successfully estimating short-term performance is nearly impossible. In the long run, I believe, volatile movements due to events outside an investor's control such as lawsuits, political concerns, or simply pure speculation are mostly leveled out as companies with the best financials prevail with the greatest appreciation of their share price. What I'm trying to get at is that each year, there are several companies whose stock outperforms the market when their fundamentals are very poor. Take Tesla for example. By no means am I saying it is a bad investment, but in the long run, the company will certainly have to start making a profit or investors will take their money to other stocks that can generate more value and are more reliable. With a system such as mine that is able to provide a snapshot of where a company lies financially compared to some of its competition, I'm hoping to identify early which businesses are going to outperform its peers in the long run. Also, by updating these scores each year, I'll be able to see if a company is improving its place among its competitors or if it's losing ground. Having the ability to see these trends can influence investment decisions as well, as a company who is improving their score each year may be a candidate for a future market leader- even if they still have a poor overall score. For example, maybe Tesla currently has a cumulative score of 4 this year, followed by a 3.4 the next year, and then a 3.2 the third year. This score may still be on the bottom half of the other 5 stocks used in the analysis, but the improvement it's showing could be used as an indicator that its financial position is greatly improving along with it's potentially gaining ground on some of its competitors.

There's a few things that I want readers to understand about my research using ratios. First of all, I'm not trying to advertise this as a sure way to pick stocks that will outperform the market. As many of you know, ratios can be useful yet have their limitations. I try to alleviate some of these concerns by incorporating a wide variety of ratios that touch on many parts of the business, so ideally shortcomings of some ratios will be balanced out with strengths of others. The second thing I want people to understand is that I don't plan on comparing scores across industries. If I did this, I might find that a stock with a really good score in the telecommunications industry was outperformed by a cybersecurity stock who had a worse average score. Since cumulative scores are calculated using only data from companies within the same industry, individual cross-sector comparisons will prove to be worthless. What can be fairly analyzed, however, is the average performance of all number 1 and 2 ranked stocks relative to the average performance of 4 and 5 ranked stocks, which is one thing i have looked at and plan on continuing to look at.

Past Performance

I only have one year of data, but it serves as a solid baseline of information. So far, I have analyzed 7 different industries (35 companies) and want to share some of the summary statistics I came up with:

1. The average return of stocks rated 1 or 2 in their category returned 24.3% in their last fiscal year, while stocks rated 4 or 5 in their category returned only 12.15%.

2. A stock ranked 1 in their category outperformed the number 5 ranked stock in that category 85% of the time (6/7 industries).

3. Stocks with a cumulative score below the mean of 3 averaged a 22.92% return while scores above this yielded 10.79%.

4. Stocks included in this research are: TAP, BUD, OTCQX:HEINY, STZ, DEO, VLO, MPC, RDS.A, XOM, ANDV, SYMC, JNPR, PANW, FEYE, FTNT, USM, TMUS,T, S, VZ, ABBV, MRK, GILD, PFE, JNJ, WFC, JPM, C, GS, BAC, TGT, WMT, AMZN, COST, HD

Moving Forward

Since a year has passed since I first began these rankings, it's time that I update my analysis. I'll be showing these updated rankings in my next articles, along with comparing them to last year's. I plan on still keeping records of performance of these stocks, along with adding more companies to the analysis in hopes of adding more statistical significance to the research. Again, by no means is this model perfect, as it ignores the mass amount of speculation that exists in today's current market. That being said, my hypothesis remains that in the long run, the shortcomings of using ratios to analyze companies will be outweighed by the merits they provide about the financials of a company.

As a beginner to investing, nothing about my research process is set in stone. Readers who have suggestions that they feel would provide better results or thoughts on necessary tweaks to my analysis, your feedback is welcome.

Disclosure: I am/we are long FTNT, JNJ, T, VZ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.