03/30/19 SIFTING FOR CLUES

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SIFTING FOR CLUES
Whatever your investment style, there are lots of valuable tips to be gleaned from the performance of the BW 50
Cheaper stocks do better, right? Wrong. At least not over the past year among the 500 companies in the Standard & Poor's stock index. Cheap stocks--defined as those with price-earnings ratios below their industry's average--actually returned a bit less to shareholders than those priced at premium multiples. That's one surprise we discovered when we went back and checked the first-year investment performance of the companies in BUSINESS WEEK's exclusive rankings of the S&P 500.
The reason for the look back was simple: the BW 50 and the accompanying Performance and Industry Rankings present a detailed portrait of how America's top companies have done over the last three years. But how can active investors use this wealth of data to decide where to put money today? To determine that, we analyzed last year's rankings to see how some of the best--and worst ranked companies on last year's list have since done for shareholders. And whatever your investment style--value, growth, or somewhere in between--there were plenty of tips to be gleaned.
In the 12 months since we published last year's rankings, the BW 50 companies saw their stock prices rise an average of 47.7%. That was well above the 34.7% gain tallied by the S&P index overall. But who wants to buy 50 separate stocks? The trick is to find ways to sift through the data to select a smaller number of companies likely to deliver top returns.
The best place to start is with the Performance Rankings. With a quick glance through each company's letter grades, you can readily see its individual strengths and weaknesses. That can provide plenty of fodder for screening stocks. Take Gillette Co., for instance, which fell from No.28 to No.38 this year. The reason: Despite top grades elsewhere, Gillette received poor marks for one-year sales growth and one-year shareholder returns. Both focus on the short term; over three years, Gillette gets ''A'' grades in both categories. Momentum investors interested only in growth would likely take that as a signal to stay clear. But for those willing to bet that 1997 was just a temporary stumble, it may be a lead worth following.
Or look at the case of wireless phone company Airtouch Communications. Although the long-dormant stock garnered a lowly ''D'' for shareholder returns over the three-year period, its soaring shares earned an ''A'' for investors over the last 12 months. A sign of a turnaround at the company, which jumped from No.206 to No.55 on this year's list? Maybe. Airtouch merits an ''A'' in nearly every other category.
For those who want more to go on, and aren't put off by some number-crunching, the next place to turn is the Industry Rankings. These offer a far more detailed portrait of how the S&P 500 companies performed--and, with the right analysis, some telltale signs that may lead to future stock market profits.
What criteria are most important? It depends on your investment philosophy. Value investors looking for under-appreciated gems may want to focus on stocks with low price/earnings ratios relative to industry peers. For growth-oriented investors, a winning company may be one that outperforms rivals. Digging into the numbers from last year's Industry Rankings, we discovered three key guides to use when you're ready to sift through this year's data.
RANK WITHIN INDUSTRY COUNTS. Companies that ranked No.1 or No.2 in their industry a year ago continued to outperform. For the 12 months ended Feb. 27, they boasted average total returns--stock appreciation plus reinvested dividends--of 40.5%. That's more than nine percentage points above the S&P's overall average on the same basis. And bottom-fishers beware: Companies that ranked near the bottom of their industries underperformed the S&P again last year.
PROFIT MARGINS ARE KEY. One crucial measure of increasing efficiency is improved profit margins. That's why our Industry Rankings include two years of margins. To test how that translates to stock market gains, we did a simple calculation: If you had used last year's rankings to pick stocks with rising profit margins, how would your portfolio have done? Pretty well, indeed. Companies that boasted margin growth in 1996 turned in shareholder returns averaging 36.2% for the 12 months through February. And only 8% of those companies delivered negative returns for shareholders, vs. 13.3% of the overall S&P 500.
STUDY RETURN ON INVESTED CAPITAL. Companies with high return on invested capital often turn in outsize stock market gains. Why? Since ROIC includes profits flowing from all the money a business has working for it, it captures most fully any enterprise's ability to deliver total returns to shareholders. That certainly proved true for the companies on our 1997 list: Those ranked in the top one-fifth in terms of ROIC averaged returns of 37.4%. Those in the bottom fifth returned 27.6% to investors.
Given the stellar results produced by screening the S&P 500 companies using those three criteria, what kind of performance would an investor get by combining them? It turns out that 14 companies on last year's list were ranked one or two in their industry, had growing profit margins, and were in the top fifth in terms of ROIC. Had you bought their shares, you would probably be very pleased: Only one of the 14 lost money for investors last year--Andrew Corp., whose shareholder return fell 26.3%. The group on average performed splendidly, returning 56.8%. That relatively small universe included Dell Computer Corp., which boasted a sterling 298.9% return. Yet even omitting Dell, the other 13 companies returned 38% on average.
Let's say you're building a portfolio today and want to apply those criteria to this year's BW 50 to find stocks that may be worth researching. Who pops up? A total of 15 stocks, which are listed in the second half of the table above. Microsoft Corp. and Dell are there, but so are surprises such as No. 225 USX-U.S. Steel Group.
So do top industry rankings, growing profit margins, and high ROIC provide a passport to stock-market success? Of course not. For one thing, what worked so well in last year's vigorous market might not in a bear market. Also, sorting through the strong performers isn't the only way to pick stocks.
What if you prefer to hunt for bargains near the bottom of the barrel? Say you had taken the opposite approach from that outlined above, and used last year's Industry Rankings to pick laggards with narrowing margins and who had ROIC in the bottom fifth. Turns out you wouldn't have done too poorly either. You would now have a 15-stock portfolio that returned a better-than-average 35.7%, powered by Navistar International Corp.'s 215.6% surge. But leave Navistar out and the average return sinks to 22.8%--and six of your stocks would be underwater.
Apply those criteria to this year's Industry Rankings, and what companies would you be adding to your portfolio? The bottom feeder's picks would include such stocks as Fruit of the Loom, Polaroid, Novell, and Dow Jones.
The market undoubtedly will give investors new ways to spin the data this year. But as you bring money to the market now, applying the lessons of the past year to today's Industry and Performance Rankings may tilt the odds in your favor.
By Robert Barker

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