Lou Mercer: Great. We'll continue to take some questions here right after I go through my piece. So please, if you're at home watching, ask questions right there on your screen or through Twitter.
So something I like to do is I'll wake up, just like everyone else, and check the CNBC app, and really figure out what's moving for the day. I'll move to the Schwab website and really get that market perspective on what economic numbers came out, what companies are reporting that day, etcetera.
People love the Schwab hold - the Schwab phone number, the hold music. So when you call Schwab, it's actually that same perspective right there on the phone line, and unfortunately, Schwab answers the phone so darn fast that people have -
Lou Mercer: - literally asked to be put back on hold to listen to some of that market perspective.
But as I go through mine, what I really want to focus on is a couple of strategies that I look for, that's a little different to what people normally will see. And one thing I'll do is I'll look for stocks that are in up trends. So I want to buy strength. I want to buy stocks that are going up. If I ask people, as we do these workshops, what makes them buy a stock, generally, they'll say they're buying stocks that have high earnings per share growth forecast, right? So these are the sexy names, the companies that people believe are going to really grow. Or they're looking for companies that every analyst out there likes.
And what Schwab actually did is we said, well, what if you bought stocks based on the stocks analysts all like and stocks that have the highest earnings per share growth forecast? And what do you think happened? Would you have outperformed or underperformed?
Randy Frederick: I'm going to guess it's underperformed.
Lou Mercer: You bet. You would have underperformed. So Schwab looked at this long 20 year period, at 2,500 of the largest companies, and then we broke those 2,500 companies into 5 groups from 1 to 5. Group number one there, if you could see it in blue, are the companies that analysts like the most.
So I started in the industry in the mid-nineties. I started with E*Trade. I wanted companies go up. I watched analysts not like the company. I watched the company keep going up. And then finally, analysts raised their opinions. Right? And then as that company is going down, down, down, down, down, I've seen too many people hang onto that losing position, because they said, well, the analyst likes it. The price target is way up here. Why am I going to sell now?
Well, sure enough, the stock keeps going down, and then slowly but surely those analysts might lower their opinion. Traditional analysts are top heavy. Almost all their recommendations are either buys or holds. Very few times do they actually have a sell recommendation.
Lou Mercer: So Schwab said, there has to be a better way, and we came up with our own school grade type system, looking at close to 3,000 companies, Russell 1000 and the Russell 2000, and what we're trying to do is not time when to buy stocks and when to sell stocks, but we believe you should own equities. We're trying to help you with which stocks to own.
So the idea here is we are going to look at fundamentals, valuation momentum and risk, stack rank companies, make them sector neutral, so energy is going to have an A rated stock, and health care might have an A rated stock. You can't compare them to each other, but our idea is the A rated energy company is going to do better than the D and F.
Randy Frederick: So it's all relative to the stocks that are their peer set, if you will?
Lou Mercer: You got it. You got it. So once - and if someone bought stocks simply based on all analysts out there liking it, they would have underperformed any other quintile, including the 500 companies that analysts like the least, the second least, the third least, and the fourth least.
The other way traditionally I hear people want to buy stocks is by buying the companies with the highest earnings per share growth forecast. And once again, we did that same study over a 20 year period, looking at 2,500 different companies, breaking them into five quintiles. Group one, the 500 stocks that had the highest earnings per share growth forecast, underperformed every other group, including the companies we didn't believe would grow as much in that quintile number five.
Randy Frederick: Well, I think an important point about Schwab equity ratings, which is different than most of the other ratings systems that's important to point out, is that as you mentioned, and I think you mentioned this, but you didn't go into it in detail, is that it's designed not to be top heavy. You will find that there are more C rated stocks, and there are fewer Bs and Ds, and then there are even fewer As and Fs. And it's all relative based on their peers, and it's designed - because frankly, there are going to be more stocks that move sideways, and there are going to be fewer that outperform and underperform, and those that are extremely out-performers, which would be the As, are going to be even a smaller set.
If you go back to - I mean, there are all kinds of extreme examples. In 2000, right before the whole internet thing started tumbling down, something like 93 percent of all stocks in the internet sector were buy - had buy ratings from Wall Street. Come on. We know that's not right.
Lou Mercer: So something I might encourage you to do with this information is look for those A and B rated stocks from Schwab if you're looking for things to buy. Look for those stocks that have their 50 day simple moving average above their longer term 200 day moving average. So you're finding those long term up-trending stocks, or that's what you're looking for.
But combine that with the stocks that analysts like the least. So the idea here is as those companies still go up, those traditional analysts are going to change their opinions, providing future catalyst for those stocks. As always, if it goes against you, you have that exit strategy, you have that emergency exit to go ahead and take your loss.
Lee Bohl: Right. And I think it's been shown through behavioral finance that analysts are slow to react. That's why you get momentum one way or the other. So I just remember Enron. I've been in the business longer than you. And it was - you know, it went down 30 percent, the analysts really liked it. It went down 50 percent, the CEO is great, it's a screaming buy. It went down 90 percent, we might not like it anymore. You know?
Lee Bohl: So I think you've got to use more of a model-based approach, and that's what I like about Schwab equity ratings. It's not somebody's bonus on the line if they try to fade things one way or another. You know, it's right there. It's all based on -
Randy Frederick: It's in the numbers.
Lee Bohl: It's in the numbers.
Lou Mercer: And I'm a cynical type person. I don't trust just about anything out there. I want to prove it for myself. And what I love about the Schwab equity ratings is we don't make a market in stocks. We don't hold inventory in stocks. So we're not saying, oh, go out and buy the A so Chuck himself can sell his A rated stock. It doesn't work that way.
The other thing is we're extremely transparent. At any point you could look online and see what a stock was rated for the last three years. You can also go back and see how well the As, Bs, Cs, Ds, and Fs - and actually which stocks were in those groups on any 52 week period since we started this back in 2002.
Now if you're a Schwab client, you can see these ratings. If you're not, it is a 52 week forecast, but we've shown even on a 4 week and a 13 week the As and Bs still will outperform those Ds and Fs.
Randy Frederick: Yeah, I think that's an important factor. I speak a lot to active traders, and yes, it's a 6 to 12 month time horizon, but honestly, if I'm doing a strategy that only lasts 30 days, would I rather be long 30 days on an A rated stock or long 30 days on an F rated stock? I frankly would much rather have an A rated stock.
And I think, and it may be obvious, but maybe not to everyone, is that everything we're talking about sounds complicated. It's very easy. If you go to the equity research page on Schwab.com, you can get all of the lists. You can get the As, the Bs, the Cs, the Ds, the Fs. You can get the ones that were recently upgraded from Bs to As, which is a personal favorite list of mine. I want the ones that are just becoming As, rather than the ones that have been As for a long time, because me, I feel like there's maybe more potential there.
And you can use the stock Screener to include the equity ratings and all the factors that Lou was talking about, and you can create a custom screen. And even better, you can name it something, like this is my great list, and save it, and it'll be there forever. I've got stock lists I created 15 years ago that are still on my Schwab.com website. So this is actually all very simple to do, and if you don't know how to do it, you can find out how to do it on the website, or call somebody on the phone and they'll walk you through it.