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Updated Schwab Industry Ratings by Jeffrey P. Ryan, CFA, Senior Equity Researcher, Schwab Equity Ratings®, Schwab Center for Financial Research August 27, 2008 Reprinted from the August 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients. Investing in stocks is never easy. But especially in times of high market volatility, you need discipline, an understanding of risk and your tolerance for it, and a proven, consistent investment process. An important part of that process is understanding the forces that influence individual stock returns. Although investment returns are mostly influenced by market moves, academic research finds that, on average, about 10% of returns can be attributed to industry performance—which is why we introduced Schwab Industry Ratings® last year. Recently, we've made enhancements to the tool that we hope will make it even more effective. While we consider Schwab Equity Ratings to be our core stock selection tool, we've found that pairing it with Schwab Industry Ratings (within the context of a well-structured investment plan) can increase its effectiveness. We believe that when used together, these two ratings systems can help you generate investment ideas and save research time—and hopefully improve your portfolio performance as well. What changed? In an effort to make Schwab Industry Ratings more effective, we increased the number of criteria used to rank industries to 14 (from 10 originally). Of these, 11 are new and three have been reformulated to help provide better predictive power. These 14 factors fall into five categories: the original fundamentals, valuation and momentum, plus growth and risk—two new perspectives that we believe can help us better evaluate the relative industry return outlook. We also changed the measure we're seeking to evaluate. Schwab Industry Ratings used to estimate average industry returns. Now it evaluates capitalization-weighted returns, where the larger the company, the greater the weight it has on the estimated performance of its industry. This new approach is in line with industry practices, and we think it's more appropriate. What got better? Our research involved extensive simulations of past market history and the predictive power of various factors. The simulations we ran covered rolling 52-week periods from December 31, 1989, through May 31, 2008. The universe of stocks that we used was the 3,200 largest stocks, by market capitalization, traded on U.S. exchanges (the same universe we use for Schwab Equity Ratings). Here's what we found:
 How you can use Schwab Industry Ratings Though it may be tempting to rush out and try to load up on double-A stocks only, we believe it's better if you don't. The result would almost certainly be an undiversified and unduly risky portfolio lacking in stocks from several sectors. Instead, consider using the three-step process illustrated in "Three Steps to a Sturdier Portfolio" above. Step 1: build your portfolio Stick to the long-term asset allocation plan that meets your goals and risk tolerance. Keep your portfolio well diversified, particularly across economic sectors. And use Schwab Equity Ratings as your primary stock selection tool, as it has tended to estimate stock performance more accurately than Schwab Industry Ratings. Step 2: select your stocks Buy A- or B-rated stocks in industries rated A or B. If there are no A- or B-rated industries in a given sector—say, financials and telecom currently—find the best-rated stocks in the best-rated industries in that sector. Step 3: maintain your portfolio Sell any D- or F-rated stocks, regardless of their industry rating. Consider selling C-rated stocks in F-rated industries. And finally, replace stocks you sell with double-A-rated stocks whenever possible, staying diversified across sectors. To learn more about the new Schwab Industry Ratings, clients can log in to Schwab.com and visit Quotes & Research > Industries. To shop for your own double-A's, use the Schwab Stock Screener. In the window that pops up when you click on Stock Screener, select Analyst Ratings under Screen Criteria. Check Schwab Equity Rating and Schwab Industry Rating, and click on "A" for both. Finally, click Total Matches to see the results. As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started. Important Disclosures 1. The return-to-risk ratio is the average of all 12-month buy-and-hold returns over the test period (December 31, 1989, through May 31, 2008), divided by the standard deviation of those returns. 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. Schwab Industry Ratings provide Schwab's outlook for industries based on Global Industry Classification Standard (GICS) groupings, such as Beverages, Pharmaceuticals and Software. Ratings are assigned using an A, B, C, D and F rating scale and can be helpful in evaluating which industries investors may want to emphasize within a specific sector. 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 types of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Examples provided are for illustrative purposes only and are not intended to represent results that a client should expect to achieve. Past results are not indicative of future performance. Diversification strategies do not assure a profit and do not protect against losses in declining markets. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (0808-4246) Return to Top |
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