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Schwab Equity Ratings® Foundationsby Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial ResearchAugust 4, 2009 Schwab Equity Ratings is our unique methodology for identifying stocks that we believe will outperform or underperform the market during the next 12 months. Every week, Schwab Equity Ratings rates approximately 3,000 U.S. corporations—that's about double the number rated by most other brokerage firms. And unlike traditional brokerage firms, we rate an equal number of stocks "buy" as we do "sell." Here, we'll help you understand the foundations of our methodology so you can start using Schwab Equity Ratings in your portfolio right away.
Surprise AnticipationIn a highly efficient market, like we have in the United States, a stock's current price reflects the collective opinion of all market participants—meaning you can't expect to use widely available information to identify undervalued stocks. Consequently, our first equity research principle states that fruitful research must be a process of discovery. There's no reward to research that uncovers what's already known. And don't assume that something new to you is necessarily new to everyone else. Our second equity research principle concerns information relevancy. Research must focus on discovering facts likely to move a stock's price as they become known by other investors. Just as there's no reward for finding what's already known, there's no reward for knowing facts immaterial to a company's market value. The next time you pick up a research report, look at its content with a critical eye. Do you see information likely to be unknown by most other investors? If so, is that information likely to move the stock price? My bet is that you'll usually answer "no" to both questions. What is worth forecasting? Professional stock analysts focus much of their time attempting to forecast companies' future earnings growth. Clearly, perfect foresight of future earnings would be valuable information, but that brings us to our third research principle: The fact that a correct forecast could have value is not sufficient reason to attempt such a forecast—one must also be able to make correct forecasts at a rate higher than chance alone. For example, state lotteries have a large payoff if the numbers you select (your forecast for the drawing) end up being correct. It's that large payoff that lures in participants. But an economically rational person won't buy a lottery ticket because there's no way to apply skill to increase the odds of successful number selection beyond chance alone. Furthermore, the average payoff is negative, since states keep a significant portion of funds wagered. Those who avoid lotteries are implicitly applying the mathematical expectation formula learned back in high school algebra, which states: Expected average reward to a forecast = payoff for a correct forecast × probability of making a correct forecast In my experience, investors often focus too much on the potential payoff of a correct decision and not nearly enough on the probability of making a correct decision. For example, take market timing. The payoff from correctly forecasting stock market direction would be huge, which for decades drew investors into researching market timing strategies. Fortunately, most investors have learned that there's little evidence anyone has discovered a timing strategy with a success rate better than chance. Are earnings per share (EPS) worth forecasting? To quantify the value of accurate EPS forecasting, a few years ago, Schwab measured the potential returns an investor could have earned with perfect foresight of EPS growth one year into the future. If it were possible in advance to buy the 20% of stocks with the highest subsequent one-year EPS growth, your portfolio would have grown an average of 38.7% annually from 1986 to 2004 versus only 14.3% annually for all stocks included in our study. In contrast, a portfolio of the 20% of stocks with the lowest EPS growth (a negative growth rate in most cases) would have lost an average of 10.4% annually. Clearly, accurate EPS forecasting could have a large payoff, but what's the probability of actually making accurate forecasts? Unfortunately, accurately forecasting EPS is extremely difficult. Historically, Schwab research has found that only 15% of quarterly EPS forecasts are within 1% of actual reported EPS. If at the beginning of each year, you bought the 20% of stocks with the highest consensus one-year EPS growth forecasts, your portfolio would have slightly underperformed the average stock included in our study. In other words, our findings have shown that analyst forecasts have historically been so inaccurate that basing stock purchase decisions on one-year EPS growth forecasts has been a completely futile approach to outperforming the stock market. Forecast "surprises," not earnings So if forecasting EPS isn't viable, what should you forecast? It's critical to understand that a company's stock price is based not just on its current fundamentals, but on all expected future cash flows, discounted back to the present according to anticipated risk. In other words, today's stock price reflects consensus expectations of future fundamentals. Consequently, meaningful stock price changes occur only when investor expectations change. And since expectation changes are triggered by the unexpected, a key element to a market-beating stock selection strategy is "surprise anticipation." Successful equity research must be able to identify stocks that perform better than the expectations embedded in their stock prices at the time of purchase. If your stock picks experience positive surprises more often than negative surprises, you have a good chance to outperform the market in the long run. Unfortunately, investors often fail to appreciate the importance of expectations. For example, they cling to the notion that great companies will be top-performing stocks, forgetting that such greatness is generally already reflected in stock prices. Surprise anticipation sounds nice, but is it actually possible to forecast the unexpected? The good news is that what is a surprise to most investors doesn't have to be a surprise to you! Behavioral finance researchers have discovered that investor expectations tend to err in two predictable ways.
 Schwab Equity Ratings: a surprise anticipation tool If applying all of these research principles sounds like a lot of work, consider using Schwab Equity Ratings as a time-saving shortcut. Schwab Equity Ratings are, in essence, a sophisticated surprise anticipation tool. Indeed, since the ratings were launched in May 2002, through June 2009, A-rated stocks have reported quarterly earnings above consensus forecasts 73% of the time while F-rated stocks have beat consensus forecasts only 41% of the time. We believe surprise anticipation is a key reason why A-rated stocks have outperformed the average rated stock by over 4.0% per year on a 52-week buy-and-hold basis since inception, while F-rated stocks have underperformed by 6.2%, as of June 9, 2009. Successful equity research must be a process of discovering relevant information. When you buy a stock, you are implicitly forecasting that you know something material that other investors don't know. It seems to us that professional analysts who focus their research on EPS forecasting and investors who use those forecasts haven't accepted the fact that earnings forecasts have historically been too inaccurate to be the basis for a successful stock selection strategy. Fortunately, we believe there is a more reliable forecasting strategy available to investors called surprise anticipation. To learn more about how to anticipate surprises, read "Traits of winners and losers." Return to top Traits of winners and losersSurprise Anticipation is a key element to any successful investment strategy. Therefore, equity research must be focused on discovering relevant information about stocks that other investors don't already know. Sounds sensible, but how does one actually implement a surprise anticipation strategy? Fortunately, you don't have to be Albert Einstein, Sherlock Holmes or even Warren Buffett to uncover material facts about stocks that other investors don't fully appreciate. At Schwab, we believe what really sets us apart is the unique research approach embodied in Schwab Equity Ratings. How Schwab's stock research differs One unusual research technique we have used is called "perfect foresight analysis." The basic idea is to ask, "If we consider all the information about each stock that will be public knowledge a year from now, what limited set of facts would be most useful to know today?" Aside from knowing next year's stock price, nothing is more profitable than knowing which stocks are going to report the largest earnings surprises, which is why Schwab believes surprise anticipation is such an important equity research objective. Fortunately, you don't need perfect foresight to get surprise anticipation working for your benefit. Schwab research has found that companies that subsequently perform better or worse than current consensus expectations have some distinct traits. As the "Surprise Anticipation Matrix" graphic below illustrates, stocks with low but rising expectation levels tend to report positive surprises. To identify these opportunities, we look for stocks with traits such as:
To identify stocks likely to report negative surprises, we just flip the parameters of the criteria listed above. Surprise Anticipation Matrix  Beyond earnings surprise Extending our research beyond earnings surprise anticipation, Schwab’s research team has studied stocks during decades of history, attempting to answer the elusive question, "What are the common traits of stock market winners before they become winners, and the traits of losers before they become losers?" Schwab Equity Ratings are based on a short list of factors we have found historically to be correlated with subsequent returns. For example, we believe one of the most reliable indicators is a company's cash flow (in other words, cash from operations less dividends). Stocks with high cash-flow (CF) levels and growth rates have typically outperformed those with negative and/or declining cash flow by a wide margin over the following one-to-two years. (When Schwab back-tests stock selection factors, we look at seven different holding periods [1, 3, 6, 12, 18, 24 and 36 months]. "One-to-two years" is an attempt to characterize the longer-term performance of CF-based factors.) Furthermore, we've found cash flow generation is far more correlated with subsequent stock returns than net income generation, which is what most investors focus on. Based on these research findings, cash-flow metrics drive two of the current 20 factor inputs to compute Schwab Equity Ratings. The key factors we use in Schwab Equity Ratings are Fundamentals, Valuation, Momentum and Risk. Learn more about the traits we examine in an attempt to distinguish future winners and losers. If you're a client, check out these online resources:
Few investment professionals use anything resembling the Schwab research approach that seeks to systematically identify stock traits that foreshadow positive surprises and market-beating returns. Instead, many analysts and portfolio managers rely on fact-finding, experience and judgment to make investment decisions on a stock-by-stock basis. While this traditional research approach can work, historically the average equity portfolio manager and analyst recommended lists have underperformed stock market indexes. Investment lessons from the world of baseball Investing is not the only endeavor where quantitative analysis has been used to outperform subjective judgment. A few years ago, a best-selling book called Moneyball told the story of the Oakland A's, who pioneered using a statistical approach to analyzing players and game strategies to compile one of the best records in baseball in recent years, despite being limited by a shoestring payroll budget. The parallels between what Oakland learned from objectively researching baseball success and what Schwab has learned about successful stock selection are fascinating. Here is one particularly relevant lesson. To play the odds, you have to know the odds Baseball executives are paid to win. They want the best players on their teams. Baseball managers seek strategic advantage in close games by substituting relief pitchers or pinch hitters and by trying to manufacture runs with stolen bases or sacrifice bunts. But how does one determine who are the best players? How does one decide whether a sacrifice bunt is worth the risk? Traditionally, baseball teams have used experienced managers to make such decisions, who supplement gut instinct with selected statistics. Hitters are measured by batting average, fielders by fielding percentage and pitchers by the speed of their fastballs. But baseball can be subjected to much more intensive scrutiny. By doing so, the Oakland A's discovered that conventional baseball wisdom is often wrong. For example, they learned that on-base percentage is a better indicator of a hitter's run contribution than batting average and that attempting a sacrifice bunt significantly lowers the likelihood of scoring. By explicitly linking player statistics and game scenarios to actual outcomes (i.e., runs scored), the A's were able to tilt the odds in their favor as they select players and execute game situation strategies. Not surprisingly, the baseball establishment initially reacted very defensively to the decision-making approach used by the Oakland A's, despite their success. But today, almost every team employs an expert in predictive statistics. An exclusive solution for Schwab clients Wall Street had tended to cling to the tradition of using analyst judgment to make stock recommendations. But we believe you can do better. By rigorous analysis of investment outcomes (i.e., stock returns), we believe we have discovered key statistics that historically have increased the likelihood of finding stocks that report positive surprises and outperform the market. We believe Wall Street's hesitation to embrace this alternative research approach is a great opportunity for Schwab clients. Return to top FundamentalsIn "Surprise anticipation" and "Traits of winners and losers," we presented the philosophical research underpinnings of Schwab Equity Ratings. Our ratings are based on almost two decades of research focused on how to systematically identify the common traits of stock market winners and losers. To help users understand the rationale behind a stock's Schwab Equity Rating, we have grouped our research concepts into four broad investment perspectives: Here, we'll explore the research behind Schwab Equity Ratings' Fundamentals component. Fundamentals defined We use the label fundamentals to encapsulate factors driven primarily by financial statement data. During the years, we have examined almost any imaginable ratio, growth rate, and relative relationship that can be computed using data reported on corporate income statements, balance sheets, and statements of cash flows. Financial statement data is highly descriptive, which is useful for understanding how a company has performed in the past. However, we have found surprisingly few financial statement items that are prescriptive, or in other words, useful for predicting future stock price performance. Many widely used financial statement metrics such as revenue growth rates or long-term debt ratios have little or no correlation with future stock returns. Fortunately, we have discovered some extremely useful research concepts using financial statement data. Let's now discuss three of the most important inputs to the Fundamentals component of Schwab Equity Ratings. Cash generation Most investors focus their fundamental research on assessing a company's potential to grow its earnings. However, this research focus is somewhat inconsistent with financial theory, which states that a stock's valuation is determined by its cash flows back to the investor. Complicating matters is that when companies use the required Generally Accepted Accounting Principles (GAAP) to prepare their financial statements, reported earnings almost always differ from cash flow, often by wide margins. To learn more on this topic, read "Cash Flow vs. Earnings: Which Is More Meaningful?" Proprietary Schwab research has convinced us that a company's cash flow generation is a more important indicator of future stock returns than its earnings. Perhaps investor attention causes earnings information to be quickly discounted in stock prices, whereas cash flow information tends to be less scrutinized. But we also note that cash flow is less susceptible to management manipulation than reported earnings. We believe that cash flow from operations (reported on a company's statement of cash flows) is a key indicator of a firm's basic health. A related measure is cash flow, which we define as cash flow from operations minus dividends. Schwab Equity Ratings prefer stocks that have positive and growing cash flow, and are generating a high cash-flow level relative to invested capital. Stocks with these traits tend to reap a high return on past investments and have the cash available to fund further investment growth in the future. Schwab research has found that stocks with these traits have consistently outperformed the stock market over holding periods as long as five years. Cash usage Although generating lots of cash is certainly desirable, how companies utilize their cash is also important. For example, Schwab research has found that shareholders generally benefit when companies use cash to fund dividends, share buybacks and debt repayment. Note that these corporate actions all involve returning cash to investors, who then have the opportunity to choose where to reinvest their cash receipts. Investors may perceive these actions as decreasing risk, causing a positive stock price adjustment reflecting a lower cost of capital. Conversely, other cash uses tend to be negative indicators for future relative stock returns. For example, Schwab research has found that shareholders often suffer when companies use cash to heavily fund capital expenditures, research and development, and acquisitions. You may be surprised to learn that firms seemingly investing in their future capabilities tend to underperform. But note that these actions all involve companies investing cash on behalf of shareholders in the limited opportunity set available to individual firms. Investors may perceive these concentrated investments as increasing risk, causing a negative stock price adjustment reflecting a higher cost of capital. Operating efficiency Not only do shareholders expect companies to wisely choose among new investment opportunities, they also rightfully expect companies to make efficient use of existing assets. Examining current assets (also known as working capital) can reveal much about a firm's operating efficiency and sometimes provide clues about sales trends. For example, companies that are able to operate their businesses while reducing assets tied up in inventories or companies that are able to grow revenues without proportional increases in accounts receivable (in other words, money owed by customers) free up cash that can potentially be used more productively. In contrast, if inventories or receivables are rising faster than sales, it could be a sign that demand is falling for a firm's products or a sign that other operational difficulties may depress future reported earnings. Schwab research has found that stocks of companies that are highly efficient managers of their working capital have historically outperformed the overall stock market. Our commitment Schwab is committed to ongoing research. Accounting rules change over time, as do investor use of financial statement data. To stay ahead of the pack, we must keep looking for new fundamental indicators and re-examine the effectiveness of current metrics. While we can't guarantee our research efforts will always yield new insights, we can promise to never stop trying! Return to top ValuationValuation defined We use the label valuation to describe factors driven primarily by stock price ratios (for example, price-earnings) or measures of valuation sentiment. The goal of the Valuation component is to answer the basic question, "Is this stock currently cheap or expensive?" Of course, this is only one element of the investment decision making process. Schwab Equity Ratings' other components—Fundamentals, Momentum and Risk—are aimed at answering two critical, related questions:
Further innovative Schwab research has been focused on developing useful "valuation sentiment" gauges. Let's dive into some of our research findings in both of these areas. Price ratios Unlike financial statement metrics, Schwab research has found that most price-based valuation factors have historically been correlated with future returns (in other words, stocks identified as "cheap" have subsequently outperformed). But not surprisingly, we have found that less commonly used price ratios are often the most useful. For example, the mind-set of private equity investors can be at least partially captured in what we call the "return on capital cost" (RC) ratio. Although Schwab Equity Ratings use a proprietary formula, one way to compute the RC ratio is by dividing a stock's operating income by its total capital cost (defined as market capitalization plus total debt minus cash and investments). Conceptually, the RC ratio relates a stock's core earning power to the price one would pay to control that earnings stream. Intuitively, higher income is better for a given transaction cost level, or a lower transaction cost is better for a given operating income level. Schwab research has found that stocks with high RC ratios have historically outperformed by a wide margin. For more information, read "Invest Like a Buyout King." Another rarely mentioned price ratio that we've found useful captures a stock's balance sheet strength and liquidity by comparing a firm's cash and marketable securities levels to its market capitalization. Cash-rich firms have numerous desirable investment attributes, including staying power during times of business stress; the ability to finance growth using internal resources; and the tendency to return cash to investors via dividends, share buybacks or debt repayment. In addition, large available cash balances can help make a stock an attractive buyout candidate. Schwab research has found that stocks with the most cash have historically outperformed the stocks with low available cash. To learn more, read "Cash is King." Interestingly, we have found that two of the most commonly used price ratios are among the least effective. For example, the "PEG" ratio, which is computed by dividing a stock's price-earnings ratio by its consensus five-year EPS growth forecast, is less predictive than simply using P/E alone. Why? We find that analyst growth forecasts are often inaccurate! For further details, read "Don't Overpay Today for Growth Tomorrow." Relative valuation measures, such as comparing a stock's current price/earnings or price/book value ratio to historical averages, are also in common use. But, again, we have found these measures are less effective than P/E or P/B used alone. Why? A stock currently selling at a lower price multiple than in the past, may do so for a good reason, such as slowing growth or current business problems. Valuation sentiment Although price ratios seem like an obvious way to gauge value, Schwab research has found that watching the behavior of "informed investors" can provide additional perspective into a stock's current valuation, particularly those investors operating with a contrarian mind-set. For more details, read "Using Sentiment to Gauge Valuation." Although Wall Street analysts might seem like informed investors, remember that their collective opinion is a very close proxy for the consensus. Few Wall Street analysts appear to be consistent and accurate contrarians. One group of contrarian "smart money" comprises those who actively sell short, such as hedge funds and brokerage firm market makers. Each month, the stock exchanges report the total number of shares of each company that have currently been sold short. Schwab research has found that stocks with the highest short interest have historically underperformed significantly, while stocks with the lowest short interest have outperformed. To learn more, read "Following the Smart Money." Return to top MomentumGauging investor expectations In "Surprise anticipation," we explained how stock prices generally reflect consensus expectations of future fundamentals. Consequently, meaningful stock price changes occur only when investor expectations change. This insight means that successful equity research must be able to identify stocks that perform better than the expectations embedded in their stock prices at the time of purchase. Saying that a stock is mispriced is analogous to saying that current consensus expectations are inaccurate in some systematic way. So how does one gauge investor expectations? The place to start is current stock price. Many academics in the finance field believe the stock market is "efficient," which means that material information about a company's prospects is fully reflected in its current stock price. They argue that stock price is the perfect measure of consensus expectations. Although Schwab does not believe the stock market is perfectly efficient, we do believe that the market tends toward efficiency and, therefore, the opportunities to identify mispriced stocks are limited. A humble attitude that starts with the idea that any given stock you research is probably NOT mispriced can keep you from making many common investment mistakes. Predictable expectation changes Identifying mispriced stocks boils down to predicting expectation changes. In "Surprise anticipation," we discussed how investor expectations tend to err in predictable ways. The Momentum component of Schwab Equity Ratings attempts to exploit investors' tendency to cling too tightly to their current beliefs, which causes them to be reluctant to change their beliefs as events occur through time. Behavioral finance researchers call this tendency the underreaction effect. At the root of the underreaction effect are what are known as the status quo bias and the confirmation bias. Humans have a basic tendency to prefer things as they are and are resistant to change. In many settings in life, it makes sense to prefer the perceived certainty of the status quo over the uncertainty of change. And if we do make changes, we look for feedback that reinforces our decisions to change. Unfortunately, the part of the brain's wiring that pushes us to seek psychological comfort often gets in the way of successful investing. For example, if a company reports a positive earnings surprise, brokerage firm analysts typically respond by notching up their future earnings forecasts. But they then typically seek further confirmation and watch closely to see if the company can report strong results again the following quarter. This "anchor-and-adjust" process creates a tendency for short-term analyst forecast changes to lag behind fundamental reality. Exploiting the underreaction effect The Momentum component to Schwab Equity Ratings gets its name from the tendency for short-term investor expectation changes to trend in the same direction—in other words, to display momentum. All things being equal, if recent expectation changes have been positive for a stock, you should expect more positive changes in the near future as expectations play catch-up, but if recent expectation changes have been negative, expect more negative changes in the near future. Therefore, a powerful way to anticipate future surprises is to bet on systematic underreaction to newly reported information. Price momentum One way to exploit the underreaction effect is to compare stocks' price changes during recent intermediate time periods. By intermediate, I refer to academic research showing that stock prices appear to have momentum during time periods of six to 12 months. For example, studies indicate that stocks with the best price performance over the previous 12-month period tend to continue to outperform the market over the subsequent 12-month period while previous losers tend to continue underperforming. One warning: The time during which price momentum is measured is critical. During shorter periods of one-to-two months and longer periods of three-to-five years, stock price changes tend to reverse rather than maintain momentum. Why does price momentum work, and why is the measurement period so critical? We believe that using the six-to-12-month time frame helps ensure that the underreaction effect is at work at the extremes. For example, if a stock has performed very well for the past year, the company has probably been reporting strong fundamentals or other good news and perhaps triggering the underreaction effect that foreshadows further positive expectation changes to come. In contrast, short-term price momentum could just be a blip, and long-term price momentum could well be a sign of overreaction (more on this below). A very sophisticated stock price momentum metric is one of the 19 factors used in Schwab Equity Ratings analysis. To learn about another type of price momentum effect, see "Buy High and Sell Higher." Earnings forecast momentum A second way to exploit the underreaction effect is to monitor the earnings forecast revisions of brokerage firm analysts. As mentioned earlier, analyst response to significant company news tends to fall into an anchor-and-adjust pattern. The conservatism in analyst forecast revisions is not completely unreasonable. An analyst who is positively surprised by recent company news does not want to raise his or her earnings forecast for a company only to be negatively surprised the next quarter and have to lower his or her forecast. Nonetheless, we believe analysts' reaction to news tends to be too conservative—which creates momentum in the direction of their forecast revisions. All things being equal, research has shown that forecast revisions in one direction tend to be followed with further forecast revisions in the same direction in the future. Analyst forecast revisions are an important input to Schwab Equity Ratings. It's interesting to note that while analyst revisions tend to be conservative, the level of their earnings forecasts tends to be overly optimistic. As a result, our research indicates most forecast revisions are negative, which means that positive forecast revisions are even more noteworthy. Three caveats
RiskThe word risk is often used in investing, but rarely is its meaning clarified. The risk of a portfolio is usually defined as return volatility relative to some market index benchmark. Many individual investors prefer a more commonsense definition of risk—namely, the probability of losing money during a period of time, such as one year. Regardless of your definition of risk, we are all taught that a diversified portfolio's expected risk and return are generally related. No free lunch is available: If you desire a low-risk portfolio, you should expect low returns in exchange. Stock-specific risk Risk measurement gets much more complex when we shift our thinking from asset classes like U.S. equities and Treasury bonds to individual securities, such as IBM stock. Intuitively, we know that investing in an individual stock is riskier than investing in a broad market index like the S&P 500®. It follows that the risk of an individual stock can be separated into two components: market risk and stock-specific risk. Market, or systematic, risk is often quantified by a stock's beta, which represents the portion of a stock's price volatility that can be explained by overall market movements. For example, we know that most stocks rise when the market goes up and that most stocks fall when the market drops. The market's own volatility is equal to 1. Stocks that tend to rise and fall more quickly with the market have betas higher than 1 while less-volatile stocks have betas lower than 1. Stock-specific, or idiosyncratic, risk refers to the portion of a stock's price volatility that is unique to that individual stock. For example, a firm that reports weak earnings may well experience a big price drop, regardless of that stock's beta or the market's direction that day. Portfolio risk and reward The market tends to reward investors for incurring the higher systematic risk of investing in a diversified equity portfolio versus a diversified bond portfolio. Otherwise, why would anyone incur the extra risk of holding volatile equities versus more stable bonds? By contrast, the market does not generally reward investors for incurring stock-specific risk, because this type of risk can be easily eliminated through broad diversification. Unfortunately, investors often fail to appreciate that holding a stock portfolio with high stock-specific risk is generally unwise, regardless of whether a lack of diversification is intentional. For example, investors who expect high returns from a portfolio consisting of a few risky technology stocks are likely to be disappointed. Concentrated portfolios of even average-risk stocks do not generally produce returns commensurate with their high specific risk levels. We believe only extremely good stock pickers have any hope of delivering returns high enough to justify holding a portfolio of fewer than 30–40 stocks, which is why we don't suggest funds with focused portfolios. Another strike against stock-specific risk So far, we have learned that systematic risk tends to be rewarded in investment portfolios while stock-specific risk does not. Now, we can turn to the Risk component of Schwab Equity Ratings. First, understand that the Risk component is not meant to simply identify high- or low-risk stocks. Just like the Fundamentals, Valuation and Momentum components of Schwab Equity Ratings, the Risk component's primary objective is to identify stocks with potential to outperform the broad market. In attempting to do so, Schwab is capitalizing on some very interesting academic and proprietary research. In the early 1990s, academic researchers were surprised to learn that portfolios of low beta stocks generally performed as well as portfolios of high beta stocks. Rather than believe that the link between systematic risk and return had been severed, they proposed that beta alone does not completely capture all systematic risk. Although the academics continue to debate the systematic risk issue, Schwab and other practitioners have discovered that stocks with high specific risk tend to actually underperform the broad market. We believe that this is a fascinating research finding. Not only is there no reward to holding stocks with high specific risk, as portfolio theory argues, but actually there seems to be a return penalty for holding these high-risk stocks. Better yet for most investors, the reverse also holds true: Low specific risk stocks tend to outperform the broad market! For more on this topic, see "High Returns From Low Risk?" Gauging stock-specific risk We've identified many different ways to quantify stock-specific risk. Two metrics we have found useful relate to the geographic dispersion of a company’s operations and to its increase or decrease in its use of debt. Greater business diversification tends to lead to a reduction in stock volatility and idiosyncratic noise. It appears that greater business diversification lowers production costs, improves product market diversification, reduces the impact of individual country shocks, makes for better corporate governance, and increases the likelihood of favorable tax arbitrage, and the accessibility to favorable tax shields. Overall, in our view, business diversification reduces information asymmetries and the adverse selection costs of transacting in a given stock. These lower adverse selection costs promote liquidity-trading activity as a company’s stock returns become more directly sensitive to firm-level earnings innovations as more firm-specific information is readily available to investors. We view the increase or decrease in company debt differently than most. Traditionally, academics viewed equity as a call option on the entire firm. As a result, since option values theoretically increase as risk increases, they tended to view increasing debt obligations as “good” since increased leverage tended to lead to increased volatility. We have found that the historic reality paints a different picture. Other things being equal, equity investors usually prefer companies using available cash to reduce their total debt exposure and finding ways to self-finance projects. In reality, investors perceive debt reduction as reducing financial risk and freeing up future cash flow for other purposes. Other things being equal, equity investors usually prefer companies using available cash to reduce their total debt. Investors perceive debt reduction as reducing financial risk and freeing up future cash flow for other purposes. Therefore, the Schwab Equity Ratings favor those companies that have reduced debt during the past year. Although the Risk component is given the least weight among the inputs to Schwab Equity Ratings, we believe that incorporating specific risk directly into the stock selection process is a unique twist that further helps you construct a diversified equity portfolio with an attractive trade-off between expected returns and expected risk. Return to top How Schwab Equity Ratings are computedWondering how we compute Schwab Equity Ratings? Here, we'll answer common client questions about our unique ratings system. What is the universe of stocks covered by Schwab Equity Ratings? Schwab aims to provide guidance on stocks that greatly interest our clients. In addition, we need sufficient data for each stock in order to compute a valid Schwab Equity Rating. We update the Schwab Equity Rating universe weekly to include the largest 3,200 market-capitalization companies whose headquarters or primary operations are within the United States. Non-exchange-traded stocks are excluded, as are nonoperating companies such as mortgage real estate investment trusts (mortgage REITs), limited partnerships and closed-end funds. Stocks that don't meet the universe inclusion criteria are coded NC, for Not Covered. Stocks that qualify but lack the data to compute a rating, such as initial public offerings (IPOs), are coded NA, for Not Available. Due to regulatory restrictions, Schwab does not rate its own stock. How often are Schwab Equity Ratings updated? We recalculate Schwab Equity Ratings each weekend using freshly updated financial statement, stock price and forecast data. After a quality-control review, updated ratings are generally posted to Schwab.com on Sunday evenings. How frequently do Schwab Equity Ratings change over time? Because Schwab Equity Ratings attempt to evaluate information impacting a stock's 12-month return outlook, the ratings tend to be rather stable. Only 5%–10% of stocks experience a Schwab Equity Rating grade change each week. Such changes are more likely when companies report their quarterly financial results. Ratings changes of more than one letter grade are rare in a given week. On occasions when a stock's Schwab Equity Rating fluctuates between letter grades in successive weeks, it's usually because the stock's underlying percentile score is near a grade cutoff. Historically, about 99% of A-rated stocks have remained A's or B's after one month. After 12 months, about 70% have remained A- or B-rated and only about 5% have fallen to D or F. Future rating changes are not predictable and do not usually follow trends. For example, a stock just upgraded from C to B is as likely to fall back to C as it is to move up to an A. What does it mean when a stock is rated NR or an asterisk is next to a rating? The NR designation and asterisks flag pertinent company news. Occasionally, significant business events occur that the Schwab Equity Rating model might not adequately assess. Here are some examples: a company announcement, an acquisition offer, a restatement of past financials or a legal development. Schwab monitors news events for all A- and B-rated stocks. If we believe a business development is noteworthy but not significant enough to invalidate a stock's Schwab Equity Rating, we place an asterisk next to the rating to alert you to this pertinent news. On the infrequent occasion in which we believe a business development invalidates a stock's current Schwab Equity Rating, we code the stock NR, for Not Rated, until the issue has been resolved. How can I learn more about the inputs to Schwab Equity Ratings? Schwab.com contains a wealth of information to help clients learn about Schwab Equity Ratings. On the Stocks tab under Quotes & Research, we offer numerous active links that document how Schwab Equity Ratings are computed, their proper interpretation and their historical real-time performance. By entering a stock's ticker symbol and clicking on the Schwab's Viewpoint tab, you can see a stock's Fundamentals, Valuation, Momentum and Risk component grades. We provide further information in the Rationale Behind Our Rating panel, which details the Schwab Equity Ratings' underlying research concepts, their importance and any changes from the prior week. Of course, to preserve Schwab Equity Ratings exclusivity for Schwab clients, we do not provide the exact model formulation. To learn more, access our stock library of articles that discuss various aspects of Schwab Equity Ratings and their usage. Does the Schwab Equity Rating methodology differ according to a company's industry group or vary according to "what's working" in the current market? No. The Schwab Equity Ratings research team focuses on discovering metrics that generally have been correlated with relative stock returns, regardless of the type of company or market environment. Success in finding these "common factors" has enabled us to create a single Schwab Equity Rating model formulation for all stocks. As such, our model formulation does not change from week to week. In terms of simplicity and transparency, we feel that this stability is a great benefit to clients. Although different measures within different industries can be important at times, Schwab research has found that identifying the key common factors across all businesses is even more important for successful stock selection. And while factor effectiveness can vary through time, we believe fluctuations appear to be too unpredictable and short-lived for dynamic factor-weighting strategies to generally add value. Can the Schwab Equity Ratings be used to pick economic sectors or industries to favor? No. Schwab Equity Ratings explicitly eliminate inadvertent bets or biases towards certain sectors or industries arising from long standing factor differences between sectors or industries. For example, valuation measures, such as P/E, usually show tech stocks as being more expensive than, say, utility stocks. The Schwab Equity Ratings rank stocks relative to other stocks within their economic sector for those factors that historically have shown long-term (e.g. a decade or more) sector biases. Furthermore, the composite score is ranked in a sector-neutral manner, that is, all stocks are ranked with only other stocks in their economic sector into percentiles. The top 5% of companies in each sector is then assigned an “A” grade; the top 6%-30% in each sector is assigned a “B” grade; 31%-70% in each sector is assigned a “C” grade; 71%-95% assigned a “D” grade; and the bottom 5% assigned an “F” grade. Our research indicates that the average overall predictive power of the Schwab Equity Ratings remains about the same whether the composite score is ranked in a sector-neutral or unconstrained manner. However, the variability over time of the ratings’ predictive ability is significantly reduced when ranked within sectors. Sector-neutral ranks simplify the process of constructing a well diversified portfolio across economic sectors. Why do Schwab Equity Ratings evaluate only 20 factor inputs? Why are important facts such as companies' growth rates, profit margins or debt ratios apparently ignored? And how is soft data such as quality of management, corporate governance or upcoming product launches taken into consideration? Interestingly, Schwab research has found that many of the financial indicators commonly used by investors have historically not been useful for identifying future stock-market winners and losers. But during the years, we believe we have found numerous stock-selection factors and strategies that are effective for forecasting future relative stock returns. Schwab Equity Ratings' inputs are drawn from this "factor library" and are specifically selected to complement one another so that the composite model is as powerful and consistent as possible. Although some factors not in the model could be effective strategies, they might not complement the existing 20 factor inputs. For example, historically, dividend yield alone has been a useful tool for selecting outperforming stocks. But adding dividend yield as another input to Schwab Equity Ratings would actually tend to dilute model performance rather than enhance it. Schwab Equity Ratings attempt to capture soft, often subjective information in two indirect ways. First, we quantify sentiment changes among informed investors such as corporate managers, brokerage analysts and short-sellers. Second, if a company's great management or new product launch favorably impacts reported results, Schwab Equity Ratings incorporate this information immediately into the next rating update. Why do the Schwab Equity Rating buy, hold and sell recommendations often disagree with the opinions of other analysts and portfolio managers? Schwab Equity Ratings repeatedly assess the 12-month return outlook for each stock according to a proprietary blend of 20 performance factors. This disciplined process is executed by computer; no Schwab analyst opinion is involved. Importantly, Schwab Equity Ratings evaluate the stock, not the company. In contrast, most portfolio managers and almost all stock analysts use a more subjective process of judgment in arriving at their conclusions. Although there's nothing inherently wrong with using judgment, we believe judgment is often applied inconsistently and based on unproven performance factors. For example, Schwab research has found that brokerage analyst recommendations are highly correlated to their forecasts of future earnings growth, yet those earnings growth forecasts tend to be very inaccurate. Consequently, because the performance factors Schwab uses tend to be different from those used by other analysts and portfolio managers, it should be no surprise that our recommendations disagree with other experts as often as they agree. How does the Schwab Equity Ratings approach differ from other independently provided stock rating systems? Schwab Equity Ratings are significantly different from other ratings systems available to individual investors. For example, the stock ratings provided by Value Line® and Investor's Business Daily are based upon quantitative models driven primarily by momentum-oriented indicators. Therefore, we find these ratings sources have tended to have a narrow short-term focus and high rating turnover. Schwab Equity Ratings evaluate a much greater breadth of inputs—Fundamentals, Valuation and Risk, in addition to Momentum—and tend to have a longer-term focus and lower turnover. Despite their outward appearance, the stock ratings provided by Standard & Poor's and Morningstar® are based on analyst judgment and, therefore, subject to all of the concerns mentioned previously. Does the Schwab Equity Ratings research approach ever change? During longer periods of time, the pricing inefficiencies captured by models like Schwab Equity Ratings tend to shrink as competitors crowd into similar strategies. We believe the Schwab research team's commitment to continuously innovate will help us provide value where others can't. As we discover new factor formulations and as existing factors deteriorate in performance, we periodically upgrade the Schwab Equity Ratings model to reflect our latest and best thinking. Since launching Schwab Equity Ratings in May 2002, we have revised the model formulation three times. The current version, SER version 4 was introduced August 2009. Return to top Using Schwab Equity Ratings |
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