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4 Ways Schwab Equity Ratings Can Help Your Trading

Learn about how Schwab Equity Ratings are derived and how you can incorporate them into your trading.

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Infographic: Schwab Equity Ratings

With so many stocks to choose from, traders and investors frequently seek advice or insight to help them pick stocks. Some people may seek out analysis from sell-side firms, while others may go to the data and look at metrics such as EPS (earnings per share). Of course, no one can predict the future, and there’s no fail-proof source for stock recommendations.

Still, Schwab has long believed that there is value in looking at more than just one metric—that by looking at various metrics together a “grade” may be determined for individual stocks, shedding some potential light on their quality for trading/investing.

On its face, EPS seems like a very valuable metric: it compares the company’s earnings against its share price. Theoretically, from here you might be able to gauge whether the stock is underpriced or overpriced. However, relying only on EPS to forecast stocks’ growth may not be a strong strategy—especially considering the fact that some studies have shown that random selection is actually better at forecasting stocks’ growth than using only EPS.1 So while it may be an interesting measure for taking a snapshot of a stock in the present moment, EPS does not seem to be especially useful in forecasting future returns.

Schwab Equity Ratings take into account four criteria: Fundamentals, Valuation, Momentum, and Risk. After considering each of these factors, a grade is assigned to the stock. That grade is our Schwab Equity Rating and that rating is intended to give investors and traders some insight into the stock’s growth potential.

Again, no one can predict the future, and that includes the folks at Schwab. However, Schwab Equity Ratings have produced some positive results. Whereas forecasting a stock’s growth based on EPS alone can be worse than random selection, stocks with a Schwab Equity Rating of A have outperformed the average stock return of all Schwab rated stocks by 5.5% while the average F-rated stock has underperformed it by 8.6% on a 52 week buy-and-hold basis.2

So if these statistics make Schwab Equity Ratings seem attractive to you, you may be wondering how you can employ them. Here are four ways to do just that:

1) Find Trade Ideas
It’s a very wide world of stocks, and it can be tough to know where to start. That’s why some investors and traders choose to start with Schwab Equity Ratings. For instance, consider only those stocks with grades in the A or B range. From there, you can perform further analysis.

2) Validate Your Own Idea
Whether you’re a fundamental or technical analysis user, you can go through your standard process of analyzing potential trading targets. Then, for those you believe look attractive, check out their Schwab Equity Rating to see if Schwab agrees.

3) Diversify
Diversification can be a wonderful thing for investors. For instance, when you build a portfolio, the gains on some securities can offset the losses of others. So if you’re interested in building your own portfolio of stocks, you can start with Schwab Equity Ratings and choose to include only those with strong ratings.

4) Time Your Sell
Of course, traders and investors aren’t just concerned with when to buy stocks, but when to sell them, too. The Schwab Equity Ratings change as the underlying company fundamentals change. Selling a stock that is downgraded by the Schwab Equity Ratings from A or B to C or lower can be an effective way to take profits or reduce your risk.

There are currently more than 3,000 stocks covered by the Schwab Equity Ratings. Explore them now! Your next investment idea is right around the corner.

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Important Disclosures

1. Zacks Investment Research collects analyst 5-year EPS growth rate forecasts from over 100 brokerage firms and averages the forecasts for each stock into a “consensus” long-term EPS growth forecast. Zacks also collects analyst stock ratings (e.g., buy/hold/sell recommendations) from over 100 brokerage firms, transforms the ratings into a numerical scale, and averages the ratings for each stock into a “consensus” rating.

For these tests, the Schwab Equity Ratings® Department established a universe of the top 2000 market capitalization stocks at the beginning of each year (i.e., 12/31/2005). Then, within these 2000 stocks, stocks were ranked into uniform quintile portfolios (i.e., the top 20% of stocks were ranked into portfolio #1, the next 20% into portfolio 2, and so on) based on consensus EPS growth forecasts and consensus ratings.

Stocks in each portfolio were held constant and average total returns (including dividends) over the subsequent one-year period (i.e., through 12/31/2013) were compiled for each portfolio. No transaction costs were subtracted from returns.

Past performance is no guarantee of future performance.

2. Source: Schwab Center for Financial Research: Average percent return of all 52-week periods from May 6, 2002 through February 10, 2014. Past performance is no guarantee of future results.

Limitations of Schwab Equity Ratings Model Performance

Quantitative model performance results have certain inherent limitations. Unlike an actual performance record, these results are hypothetical and do not represent actual investment performance or trading. Also, since the trades have not actually been executed, the results may have under- or over-compensated for the impact, if any, of certain market factors, such as the effect of limited trading liquidity. No representation is being made that any investor will or is likely to achieve profits or losses similar to those shown.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.