By Michael Kaye Regular readers of this column are familiar with Standard & Poor's STARS ranking system. It starts with a qualitative approach to selecting stocks. S&P analysts take into account not only financial data on companies but nonfinancial elements, including management expertise, the cyclical nature of the industry, and the strength of research and development programs, as well as other factors.
The system has worked pretty well over the last several years. From its inception on Dec. 31, 1986, through July 31, 2002, the S&P 5-STAR portfolio (those stocks with the highest ranking in the STARS system) returned a total of 940.7%, vs. the 276% gain posted by its benchmark, the S&P 500-stock index. (Like BusinessWeek and BusinessWeek Online, S&P is a unit of The McGraw-Hill Companies)
S&P also maintains a scoring system for stocks based on quantitative analysis, an investing discipline that uses only financial information derived from company balance sheets, income statements, and other sources. Using a proprietary model, S&P calculates a stock's weekly Fair Value -- the price at which an issue should trade at current market levels -- based on fundamental data such as corporate earnings and growth potential, price-to-book value, return on equity, and current yield relative to the S&P 500. Stocks are ranked in five tiers, with a Fair Value ranking of "5" indicating that the stock is significantly undervalued, implying the potential for more powerful price appreciation.
PRICE, VOLUME TRENDS. And S&P also gauges stocks from a technical investing perspective, looking at price and volume trends to help predict the future direction of a market or an individual security. One technical measure we look at is a stock's relative strength -- its momentum in relation to either other securities or indexes such as the S&P 500 or its own price activity.
The technical indicator that describes this is a relative-strength index (RSI). The higher the RSI number, the greater the degree to which the stock has outperformed the S&P 500 over a given time.
We thought we'd combine all three approaches in this week's screen. First we searched for stocks with S&P's highest qualitative ranking, 5 STARS (buy), meaning S&P analysts expect them to outperform the overall market in the next 6 to 12 months. Drawing from that list, we looked for issues with an S&P Fair Value ranking of 5. Finally, we screened for stocks with a 13-week RSI greater than 65, placing them squarely among those issues that have outperformed the S&P 500 index over that time.
Only five names made the cut:
Indymac Bancorp (NDE)
KB Home (KBH)
Nautilus Group (NLS)
Rent-A-Center (RCII) Kaye is a portfolio services analyst for Standard & Poor's