Quadrix Explained

Upside’s stock-rating system, Quadrix®, considers more than 90 variables in seven categories — Momentum, Quality, Value, Financial Strength, Earnings Estimates, Performance, and Reversion. Used together, these scores can help you find winners and avoid losers.

We believe no numbers-based ranking system can substitute entirely for company analysis. Stocks cannot be reduced to a series of equations. Often what may really matter about a company’s stock is not on the balance sheet or income statement. For example, Quadrix can tell you which drug companies have done best in growing earnings and sales, but it cannot tell you the companies with the best new drugs in the pipeline.

Still, we believe a numerical ranking system like Quadrix can be a great first screen for building portfolios. Because the system uses only quantifiable factors, it is designed to narrow the focus on companies achieving superior results. Similarly, because Quadrix is not influenced by the fear, hope, and greed that can cloud the judgment of all investors, the system is designed to provide unbiased feedback on current portfolio holdings. Quadrix has done a good job of separating winners and losers since we began publishing Quadrix scores in 2000.

Quadrix Overview

Quadrix uses more than 90 variables to score stocks in seven categories — Momentum, Quality, Value, Financial Strength, Earnings Estimates, Performance, and Reversion.

Within each category, some variables are weighted more heavily based on past effectiveness. To compute an Overall Score, Quadrix uses a weighted average of seven category scores, with Value, Quality, and Momentum receiving the biggest weightings. Based on past effectiveness or expectations regarding market conditions, weightings for the individual variables or the categories may be changed.

For the most part, Upside uses Overall Quadrix scores to find what we believe will be likely 12-month winners.

Momentum. To compute Momentum scores, Horizon ranks the universe of roughly 5,000 stocks on variables related to recent growth in earnings, cash flow, and sales. For example, a company that scores in the top 1% for 12-month sales growth receives a 100 for that variable. For a company that scores better than only 5% of the companies for 12-month sales growth, the score for that variable would be 5.

For each of the Momentum variables, each stock is compared to the universe of all stocks. To calculate the Momentum score, the sum of a stock’s scores for each variable is compared to the universe of stocks. For example, if a stock receives a Momentum score of 75, that means the weighted average of its Momentum scores is higher than 75% of the universe.

Some investors rely solely on Momentum factors when picking stocks. Horizon prefers a balanced approach, partly because companies with high Momentum scores often have overvalued stocks. Also, because our Momentum variables look back no further than 12 months, Momentum scores can unduly reward companies experiencing a temporary acceleration in business.

Still, partly because we believe it can help eliminate companies suffering from deteriorating fundamentals, Momentum receives a healthy weighting in the Quadrix system. In fact, we are wary of stocks with high Overall Quadrix scores that do not score well for Momentum. Such scores sometimes reflect a temporary slowdown, but they can also point to a stock headed for trouble.

By definition, Momentum factors are short term in nature. So, if a low-quality or overvalued stock is bought simply because of its Momentum score, the risk posed by an earnings slowdown is substantial. In our opinion, the shorter the time horizon, the more important is Momentum.

Quality. The Quadrix’s score is an excellent gauge of a company’s track record. Most of the Quality variables are growth rates for sales, earnings, cash flow, common equity, and dividends. The other variables include expected profit growth and earnings consistency, along with returns on equity, investment, and assets.

Growth rates for the past one, three, and five years are used. So, companies with outstanding 10- or 20-year track records are given no credit beyond the last five years. Companies lacking five-year track records are evaluated based on the average ranks for the Quality variables for which they do have numbers, the methodology Quadrix uses for all missing variables.

Companies with the best growth records score highest for Quality. While a good history is no guarantee of future success, companies with stellar growth records tend to be well-managed businesses with attractive market positions. Because Quadrix measures growth in five areas — sales, earnings, shareholders equity, cash flow, and dividends — it penalizes companies growing earnings through cost-cutting or restructuring charges.

One shortcoming of Quadrix is the reward it gives companies that have grown through acquisitions. Many of Wall Street’s best growth companies have benefited from acquisitions. But, in general, a company growing internally is more valuable than a company growing only through acquisitions. For that reason, Upside takes a closer look at any high Quadrix scorer with a penchant for acquisitions. 

Value. Quadrix’s Value variables include such ratios as price/earnings (P/E), price/sales, price/cash flow, price/book value, price/dividend, and P/E relative to expected growth (PEG). In addition, the ratios are compared to the average level of the ratios over the past three and five years.

We believe there are many value plays in the broader market, and history suggests such stocks tend to outperform. In real-time use since 2000 and in back-tests to 1992, Value scores have done the best job of picking winners among the category scores. Still, because of our balanced approach, Upside typically prefers attractively valued growers over deep-discount value stocks with poor track records or weak market positions.

Financial Strength. Quadrix Financial Strenght scores reflect interest coverage, debt positions, and profit margins. Financial Strength scores are designed to help weed out companies with weak financial positions. Companies with solid finances score best for Financial Strength. By itself, a company’s Financial Strength score may not be a great predictor of stock performance. However, a low Financial Strength score is a yellow flag worth investigating.

For industry groups that typically use a lot of debt — including banking, financial services, and utilities — Quadrix Financial Strength scores can be unduly low. For stocks in such sectors, Financial Strength scores are most meaningful relative to industry peers, rather than the broad market.

Earnings Estimates. By tracking the trend in consensus earnings estimates, you can check whether company fundamentals appear to be supporting a stock’s price action. Also, estimate revisions have been a good screen for avoiding companies likely to post negative profit surprises. The Quadrix Earnings Estimates score measures the change in consensus earnings estimates for coming quarters, this fiscal year, and next fiscal year. We also consider variables that reflect the number of analysts boosting estimates relative to the number cutting estimates. Earnings Estimates scores can be quite volatile, so the category does not receive a big weighting in the Overall Quadrix score. However, for stocks with low Earnings Estimates scores, investors should determine whether the stock price already bakes in negative revision trends.

Performance. The Quadrix Performance score reflects a stock’s total returns relative to other stocks. To calculate total returns, we take into account both dividends and stock-price changes. Historically, outperformance in periods of 12 months or less has been a bullish signal.

While investors should watch Performance closely, they do not receive a huge weighting in Quadrix. We believe that the shorter the time horizon, the more Performance scores should be emphasized. If Performance scores are weak even though company fundamentals appear strong, you should evaluate whether the company faces near-term problems.

Reversion. Much like the Performance score, Reversion considers total returns. However, Reversion looks at those returns diff erently, as our research suggests stocks with strong returns over periods of three years or longer tend to underperform in the year ahead. Few companies can keep outperforming in perpetuity.

Reversion doesn’t carry a high weighting in the Quadrix Overall score, though the combination of low Reversion and Value scores may indicate a frothy price, and thus greater-than-usual downside risk in the event of bad news.

Conclusion

We believe Quadrix is an excellent tool for uncovering buy candidates. Upside does not use Quadrix exclusively, since there is much that cannot be captured by a numerical system. Still, Quadrix is designed to help ensure that we are fishing in the right waters. Upside rarely initiates coverage on a stock with a Quadrix Overall score below 70.

Quadrix also is designed to be a useful tool for tracking industry groups. If most of the stocks in a group score well for Momentum, it provides some confirmation that the companies are benefiting from industry-wide trends. Quadrix is designed to help illustrate whether leading groups are gaining because of strong fundamentals.