Equity Solutions for Financial Markets

By Brent Miller, CFA
President & Director of Research, Gradient Analytics (a Sabrient Systems company)

The value of quantitative, rules-based, process-driven equity models is clear. They can be tested based on various historical timeframes and market conditions, sectors, market caps, and regions, while removing emotion from investment decisions. And with the exception of brief market periods driven by speculative fervor, investors tend to favor high-quality companies with solid fundamentals.

Sabrient Systems specializes in building fundamentals-based equity models that seek to generate alpha versus a market benchmark, including alpha factors and strategic beta indexes. In 2011, Sabrient acquired Gradient Analytics, a fundamental equity research firm with a team of forensic accounting specialists who focus on assessing earnings quality and anomalous insider activity, in part to enhance Sabrient’s quantitative model-building capabilities. Together, we leverage a unique collaboration of engineers and forensic accountants and a scientific hypothesis-testing approach to create proprietary alpha factors, multifactor models, process-driven portfolio strategies, and rules-based indexes.

In 2013, the combined team created the original version of our Earnings Quality Rank (EQRv1), a pure accounting-based risk assessment factor based on the collective experience and expertise of Gradient’s analyst team in identifying company-level earnings quality issues, aggressive accounting tactics, and misleading “financial engineering.” More recently, we enhanced the model to create EQRv2.

Furthermore, the Sabrient/Gradient team has created a variety of other valuable alpha factors, including an enhanced version of Sabrient’s flagship Growth at a Reasonable Price (GARP) model and several other factors related to value, growth, quality, and momentum. All told, we now publish the following eight “Sabrient Scores”:

1. Growth at a Reasonable Price (GARPv2)
2. Earnings Quality Rank version 2.0 (EQRv2)
3. Growth Quality Rank (GQRv2)
4. Strategic Valuation Rank (SVR)
5. Strategic Growth Rank (SGR)
6. Aggregate Price Momentum Rank (AMR)
7. Bull Score (BULL)
8. Bear Score (BEAR)

For institutional quants and systematic traders, we offer five of these alpha factors (EQR, GQR, SVR, SGR, AMR) as a factor suite (“Equity Factor Rankings”) for licensing through Nasdaq Data Link. However, fundamental analysts, financial advisors, and individual investors also find them valuable for screening, idea generation, risk monitoring, and confirmation. On a temporary basis, you can access all 8 of these Sabrient Scores free of charge through our SmartSheets products (one that provides scores for over 4,200 stocks and one for over 1,200 equity ETFs). Ultimately, they will be behind a paywall as a companion product to our powerful and comprehensive SmartLights^TM web application.

In this article, I provide further details on the purpose and basis for our Earnings Quality Rank and other alpha factors, including a summary of back-tested performance.  Read on....

  by Scott Martindale
  President & CEO, Sabrient Systems LLC

The year began with the market showing resilience in the face of the Fed’s rate hikes, balance sheet contraction, hawkish rhetoric, and willingness to inflict further economic pain, including a recession and rising unemployment (if that’s what it takes). Of course, we also had a treacherous geopolitical landscape of escalating aggression by Russia in Ukraine, by China (regarding both Ukraine and Taiwan), and North Korea (persistent rocket launches and saber-rattling). But really, the direction for stocks came down to the trend in inflation and the Fed’s response—and the latest readings on CPI and especially PPI are quite encouraging. But alas, it now appears it isn’t quite that simple, as we have a burgeoning banking crisis to throw another monkey wrench into the mix. As Roseanne Roseannadanna used to say in the early Saturday Night Live sketches, "It just goes to show you, it's always something—if it ain't one thing, it's another."

I warned in my January post that 1H 2023 would be volatile as investors searched for clarity amid a fog of macro uncertainties. And I often opine that the Fed can’t rapidly raise rates on a heavily leveraged economy—which was incentivized by ZIRP and massive money supply growth to speculate for higher returns—without fallout (aka “breaking something”). Besides impacts like exporting inflation and societal turmoil to our trading partners, the rapid pace of rate hikes has quickly lowered the value of bank reserves (as bond prices fell). Last week this in turn led to massive portfolio losses and a federal takeover for SVB Financial (SIVB) which caters to California’s start-up and technology community, as it was pushed into selling reserves to meet an onslaught of customer withdrawals. The normally stable 2-year T-Note spiked, crashing its yield by over 100 bps in just a few days. Other regional banks have required rescue or support as well, including stalwarts like Signature Bank (SBNY) and First Republic (FRC)…and then scandal-prone European behemoth Credit Suisse (CS) revealed “material weaknesses” in its accounting…and Moody’s cut its outlook on US banks from stable to negative. So, something indeed broke in the financial system.

Fortunately, inflation fears were somewhat assuaged this week, as all reports showed trends that the Fed (and investors) hoped to see. February CPI registered 6.0%, which is the lowest reading since September 2021. Despite the historical observation that a CPI above 5% has never come back down to a desirable level without the fed funds rate exceeding CPI, we already have seen CPI fall substantially from 9.1% last June without fed funds even cracking the 5% handle, much less 6%—and CPI is a lagging indicator. So, given the 12 encouraging signs I describe in my full post below, I believe the writing is on the wall, so to speak, for a continued inflation downtrend.

So, the question is, will the Fed feel it must follow-through on its hawkish inflation-busting jawboning at the FOMC meeting next week to force the economy into recession? Or will recovering supply chains (including manufacturing, transportation, logistics, energy, labor) and disinflationary secular trends continue to provide the restraint on wage and price inflation that the Fed seeks without having to double-down on its intervention/manipulation?

My expectation is the latter—and it’s not just due to the sudden banking crisis magnifying fragility in our economy. Nothing goes in a straight line for long, and inflation is no different, i.e., the path is volatile, but disinflationary trends remain intact. I talk more about this in my full post below. Regardless, given the anemic GDP growth forecast (well below inflation) and the historical 90% correlation between economic growth and aggregate corporate profits, the passive broad-market mega-cap-dominated indexes that have been so hard for active managers to beat in the past may well continue to see volatility.

Nevertheless, many individual companies—particularly within the stronger sectors—could still do well. Thus, investors may be better served by pursuing equal-weight and strategic-beta ETFs as well as active strategies that can exploit the performance dispersion among individual stocks—which should be favorable for Sabrient’s portfolios, including the newest Q1 2023 Baker’s Dozen, Small Cap Growth 37, and Dividend 43 (offering both capital appreciation potential and a current yield of 5.2%), all of which combine value, quality, and growth factors while providing exposure to both longer-term secular growth trends and shorter-term cyclical growth opportunities.

Quick plug for Sabrient’s newest product, a stock and ETF screening and scoring tool called SmartSheets, which comprise two simple downloadable spreadsheets that provide access to 9 of our proprietary quant scores. Prior to the sudden fall of SIVB, on a scale of 0-100 with 100 the “best,” our rankings showed SIVB carried a low score in our proprietary Earnings Quality Rank of 35, a GARP (growth at a reasonable price) score of 37, and a BEAR score (relative performance in weak market conditions) of 13. Also worth mentioning, Lantheus Holdings (LNTH) was consistently ranked our #1 GARP stock for the first several months of the year before it knocked its earnings report out of the park on 2/23 and shot up over +20% in one day. (Note: you can find our full Baker’s Dozen performance details here.) Feel free to download the latest weekly sheets using the link above—free of charge for now—and please send us your feedback!

Here is a link to a printable version of this post. In this periodic update, I provide a comprehensive market commentary, offer my technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals based SectorCast quant rankings of the ten U.S. business sectors, and serve up some actionable ETF trading ideas. To summarize, our SectorCast rankings reflect a slightly bullish-to-neutral bias, the technical picture looks short-term oversold, and our sector rotation model has taken a defensive posture. Technology has taken over the top position in our sector rankings. Read on…