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Schwab Equity Ratings Report Card by John Zbesko, CFA, Senior Equity Researcher, Schwab Equity Ratings®, Schwab Center for Financial Research July 9, 2008 Reprinted from the June 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients. No stock-picking system can work equally well in all types of markets—and Schwab Equity Ratings is no different. But what's particularly distinctive about our approach is its transparency. We report the performance of our ratings each week that the ratings are updated, and in this article we reveal how Schwab Equity Ratings has performed in different types of markets—as well as how you can use these insights in managing your own portfolio. Intended to be a time-saving shortcut to help clients evaluate stocks, the ratings are designed to anticipate changes in investor expectations—since any current stock price presumably reflects current consensus expectations of future performance.  In "Success Varies by Market Type," you can see that, overall, A-rated stocks have outperformed the market by an average of 9.4%, while F-rated stocks have typically underperformed by 13.5%, according to our research. But digging into the numbers, we find that the ratings' strongest performance has occurred in bear and value-driven markets. Among the ratings' weakest seasons: momentum-driven markets, when the fundamentals that drive Schwab Equity Ratings may be overlooked by investors less concerned with risk. Although the ratings were first launched in 2002, we used back-tested data from 1990 to 2002 for this analysis in order to increase the sample size and time span covered. Each stock was held for one year following the date at which a Schwab Equity Rating was assigned. With the use of back-tested data, the overall testing period included the bull markets of the 1990s and 2003–2007, as well as the 2000–2003 bear market. To find actual results since the ratings' launch in May 2002, go to Schwab.com/serperformance. Measuring performance: relative vs. absolute Key to understanding Schwab Equity Ratings' performance is appreciating the difference between relative and absolute returns. Absolute return simply measures how much a given stock has risen or fallen. But the relative return—which is what most seasoned investment advisors track—is excess return over the market or an appropriate benchmark. Our results have shown that, on average, A-rated stocks produced positive excess relative returns in all types of markets—including declining markets where absolute returns were negative. Bears vs. bulls When the stock market has climbed, A-rated stocks have shown relative excess returns of 9%, almost equal to their 9.4% overall average. But when the market has fallen, A-rated stocks have outperformed by more than 12%, while F-rated stocks have underperformed by almost 20%. Does this mean A-rated stocks will go up when the market is going down? No. But on average, A-rated stocks have declined less than the average stock—and again, we're talking relative performance. While it's never pleasant to open up your brokerage statement and see that your stocks are down 10% for the year, it certainly beats being down 22%! And when the stock market does begin climbing again—as it always has in the past—you should be out of the red that much sooner, and better positioned to benefit from any subsequent bull market. Value vs. growth On the style front, "Success Varies by Market Type" also illustrates that A-rated stocks have generated positive excess relative returns in both growth- and value-led markets. But in the latter, A-rated stocks have outperformed by 11.7%, versus 5.9% in growth-led markets. And for F-rated stocks, the difference in underperformance has been even greater: –20% for value markets, versus –3% for growth markets. The likely reasons? In value-led markets, investors are inclined to pay more attention to fundamental factors that Schwab Equity Ratings weights heavily, while in growth-led markets, momentum tends to drive performance as investors overlook fundamentals in favor of an expected growth "story." Remember the Internet/dot-com mania of the late 1990s, or consider commodities today. Since emotion-driven markets are so often unpredictable, we try to focus on what works over the long term. Small-cap vs. large-cap Schwab Equity Ratings has also seemed to work better during small-cap-led markets, with A-rated stocks outperforming by 10.4%, versus 8.3% for large-cap-led markets. Again, the underperformance for F's has been even starker: –14.7% in small-cap, versus –12.0% in large-cap.  Click to enlarge Likewise, as you can see in "Success Varies by Size and Sector, Too," the average excess returns of A- and F-rated stocks in the largest 500 of the approximately 3,200 stocks covered by the ratings (5.5%) are substantially smaller than the excess returns of A- and F-rated stocks in the smallest 1,000 rated stocks (14.4%). Presumably, larger, more widely held stocks are more efficiently priced than small, relatively unknown stocks. This would allow the smaller stocks more room to grow when small-caps lead the market. Small-caps also tend to be much more volatile, which can lead to outsized returns—or declines. Sector stars Also note in "Success Varies..." that the ratings have produced excess returns across all sectors except for telecom, where a tiny universe (on average, less than 50 stocks) may skew the results. The strongest outperformers have been health care (14.1%) and consumer discretionary (11.7%). Energy (6.3%) and financials (6.4%)—sectors that can be influenced by factors beyond the scope of the ratings, such as oil prices and the subprime implosion—have generated smaller (though still positive) relative returns. Looking for stock ideas? Clients can find the top three stocks according to Schwab Equity Ratings in each sector, updated weekly, on the Schwab Composite List. A model for all seasons No matter what the market environment—but especially during rocky times—Schwab Equity Ratings has proven to be a powerful tool to help you build and maintain your equity portfolio. Stick with a disciplined strategy. Maintain a diversified portfolio across asset classes, cap sizes, styles and all economic sectors. And above all, stay focused on the long term. Important Disclosures Past results are not indicative of future performance. 1. An "up" or "down" market is defined by whether the average 12-month total return of the approximately 3,000 stocks given Schwab Equity Ratings is positive or negative. A growth-led market is one in which the Russell 2000® Growth Index 12-month total return is greater than that of the Russell 2000 Value Index, while a value-led market is one in which the Russell 2000 Value Index 12-month total return is greater than that of the Russell 2000 Growth Index. A large-cap-led market is one in which the S&P 500® Index beat the Russell 2000 Index over a specific 12-month period, while a small-cap-led market is one in which the Russell 2000 Index beat the S&P 500 Index over a specific 12-month period. 2. Large-cap is defined as the S&P 500 Index. Small-cap is defined as the Russell 2000 Index. High- and low-growth sectors are defined as the top and bottom 25% of the approximately 3,000 stocks given Schwab Equity Ratings, based on consensus analyst-estimated future earnings-per-share growth rates. Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. The S&P 500 Index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (0708-4171) Return to Top |
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