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| The Basics | StockScouter rates potential reward, and risk
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A simple number from 1 to 10 offers investors a whole world of information.
By Jon Markman
MSN Money built the StockScouter rating system to help individual investors quickly analyze and assess a stocks potential for outperforming the broad market. Working closely with Gradient Analytics, an independent research firm at the cutting edge of financial engineering for institutional money managers, we have identified statistically predictive traits that affect the performance of successful U.S. securities and developed a systematic way to help you discover, research, hold and sell them.
StockScouter, like similar systems that cost Wall Street pros hundreds of thousands of dollars per year, depends on advanced mathematics, software, an innovative mix of measurements and historical testing to attempt to forecast the short- and long-term outlook for all U.S. companies that have traded on the three major exchanges for at least the past six months. Recently, that represented a universe of about 5,500 stocks.
In rating the outlook for stocks from strong to poor on a 10-point scale, StockScouter does not make subjective judgments. Instead, it compares the fundamental and technical qualities of individual companies and their stocks to benchmarks that have proven statistically predictive of stock performance in the past. It then assigns an expected six-month return to each stock based on this statistical profile, and balances that return against expected volatility. This ratio of expected return to expected volatility, or risk, yields a stocks final overall rating.
The balance of expected reward with expected risk is a key concept that sets StockScouter apart from other stock-rating systems. Stocks with high expected future returns will see their ratings reduced if the volatility of those returns is expected also to be high. Thus an ideal stock in our system is expected to move briskly and directly to a higher price, rather than simply briskly.
StockScouter is not perfect; no predictive rating system could be. But its models have been thoroughly tested to the highest academic and professional standards using more than a decade of historical data. And we believe that, in conjunction with the other stock research tools available on MSN Money, it will help individuals make more thoughtful investment choices by revealing the way successful professional money managers accumulate, sort, evaluate and act upon financial information.
How StockScouter works
StockScouter rates each stock in its coverage universe from 10 to 1, with 10 being best. Ratings are scored on a bell curve. This means that there are fewer stocks with a rating of 10 than with a rating of 9 and fewer stocks with a rating of 9 than a rating of 8; likewise, there are more stocks with a rating of 2 than with a rating of 1 and more stocks with a rating of 3 than with a rating of 2. Stocks thus bunch up in the middle, which is why stocks rated 4 to 7 are expected to perform in line with the market. Ratings are recalculated and updated in our database daily to reflect the most current technical, fundamental, ownership and valuation data available.
The ratings derive from our research teams systematic analysis of four key factors that either reflect a companys fundamental quality or investors ardor for their shares. We rate factor performance on a five-point scale from A to F, just as youd see on a report card. These grades appear on StockScouters Details pages along with a list of the subfactors that make up each factor. Subfactors do not get grades of their own; rather, the system tells you whether they add a positive, negative or neutral bias to the factor grade. The factor grades are also displayed for quick reference on StockScouters Summary page for each stock, and a pro/con list also summarizes the subfactors findings. Here are the four factors, and some of their key subfactors.- Fundamentals. This factor assesses a companys past earnings growth, its estimated future earnings growth and its capacity to beat brokerage analysts consensus estimate. To receive a high grade, a company generally must grow reasonably fast, beat analysts growth estimates and be expected by veteran analysts to grow earnings in the future. However, a powerful earnings surprise or big boost in estimates by an experienced analyst can also boost the grade of a stock with otherwise seemingly lackluster fundamentals.
- Ownership. This factor assesses whether a stock is under accumulation by executives and board members. To receive a high grade, a stock generally must be under accumulation by high-ranking executives or board members in significant quantities.
- Valuation. This factor assesses whether a stocks price is high or low relative to its current level of sales, earnings and expected earnings growth. Its counter-intuitive, but our research shows that big companies shares should be slightly more expensive than peers to receive a high grade. Meanwhile, as youd expect, small companies shares must be much cheaper than peers to receive a high grade.
- Technical. This factor assesses whether a stocks price trend is positive or negative. To receive a high grade, a stocks price must generally be rising at an accelerating rate over the near- and short-term. However, a stock with a very low price relative to its 10-week trend can receive a high grade if the system believes it is likely to rebound.
StockScouter does not simply average sub-factors to yield a factor grade. Instead, subfactors are added together in different weights that vary with a stocks size and sector. Likewise, factor grades are not simply added or averaged to yield a final overall rating. They are also weighted in a variety of ways according to a proprietary methodology developed by the statisticians and financial engineers at Gradient Analytics.
After all of the factors and their constituent subfactors are measured and weighed, StockScouter awards each stock a core rating. That core rating is then balanced against the standard deviation, or volatility, of the stocks return over the past 12 months to yield the final overall rating which is presented on the site. Its convenient to think of the overall rating as the ratio between expected return and expected risk. A stock with high expected return and high expected risk will generally receive a lower rating than a stock with modest expected return and very low expected risk.
A portfolio managed with guidance from the StockScouter system would attempt to stay invested in stocks rated 8 to 10 and avoid stocks rated 1-3.
Market preferences
What about the short-term? For investors who prefer to trade stocks more frequently, StockScouter also assesses three market preferences that tend to boost or hinder securities performances over one- to two-month periods. Studies have shown that stocks with favorable market preferences tend to yield the strongest performance for as long as those preferences are in favor. Think of these as tailwinds, if they are in a stocks favor, or as headwinds if they are not. These are updated in our database weekly. The market preferences are:- Sector. We have divided our universe of stocks into 12 industrial sectors, such as technology or health care, by their federal identification code. Generally, investors prefer a third or less of these sectors at any given time. We call them in favor. The rest are either out of favor or in a no-mans land we call neutral. Widely accepted academic and professional research indicates that as much as 50% of a stocks performance derives from the strength or weakness of its sector.
- Market cap. We have divided our universe into four market capitalization categories: The top 400 stocks by market cap are "large"; the next 1,000 are "mid"; the next 2,500 are "small"; and the rest are "micro." Generally, investors prefer only one or two groups at a time. We call them "in favor." The rest are either "out of favor" or "neutral."
- Style. We have divided our universe into two investment styles by price/sales ratio. High-priced stocks are categorized as part of the growth style of investing, while low-priced stocks are categorized in the value style. Generally, investors prefer one style or the other for periods lasting a year or more. We rate each in favor, out of favor or neutral.
Our historical portfolio-management research shows that the best stocks to own over one-month periods are rated 8, 9 or 10 and are a member of two, but preferably three, categories preferred by the market. In the short-term, our system would prefer a stock rated 8 or 9 with three in favor tailwinds over a stock rated 10 with just one in favor tailwind. When no sectors, market caps or style are rated "in favor," our system prefers stocks with "neutral" tailwinds. Note: Stocks are sorted into sector, market cap and style categories monthly to maintain stability, but market preferences are updated weekly to maintain freshness.
We have extensively tested a 50-stock portfolio managed according to these rules against data from the past 10 years of market history. In cases where a tie-breaker was required to choose between stocks with identical ratings and market preferences, we programmatically chose ones with the lowest expected risk. Additionally, any stock that fell 20% from the initial purchase price at the close of a trading day was dumped from the portfolio, and 5-year T-bill interest rate was substituted in its place (after accounting for the 20% loss).
How to use the system
You do not need to run a 50-stock portfolio with monthly rebalances to take advantage of the StockScouter system. If you fancy yourself an investor in large-cap stocks, use the StockScouter feature found in MSN Moneys Screener or on the Market Trends page to only find high-rated large-caps. If you prefer stocks favored by corporate insiders, then use the Screener to find high-rated stocks with Ownership grades of A. If you prefer value stocks, then use the Screener or Market Trends page to find only high-rated value stocks. If you are interested in shorting stocks, then find stocks rated 1 with low Technical or Valuation grades. And so on.
Read MSN Moneys editorial columnists regularly to learn more about how to use and profit from StockScouter.
Microsoft and MSN Money have no role in the rating of stocks and accompanying analysis, which is prepared by Gradient Analytics.
Microsoft and MSN Money are not registered investment advisers and do not advise individuals as to the advisability of investing in, purchasing or selling securities or other financial products.
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