Posts Tagged ‘earnings growth’

Quint Charts

Tuesday, September 8th, 2009

One way to study potential causal relationships is to use longitudinal portfolio-tracking methods, as frequently used in academic finance research. We define a ranking function which ranks all companies in our universe, and then group companies into quintiles based on this ranking (quartiles and deciles are also commonly used). The companies in each quintile simply form a “portfolio” whose component companies persist throughout the length of the study. We track each individual company’s performance at regular intervals, and use all the individual company performance results to calculate the performance of each of the five portfolios at those intervals. Then we summarize these portfolio results in a “Quint Chart” to try to see if there are significant and meaningful correlations between the ranking that produced the quintile portfolios and the performance of those portfolios over time.

Quint Chart Example for Earnings Growth

The Quint Chart shown here shows an example (click the chart for a full size version in a new browser window). Let’s take a look.

Quint Chart Example

Quint Chart Example

This Quint Chart uses 5-Year EPS growth to rank the companies and form the quintile portfolios. The performance of each of these portfolios, defined as year-over-year EPS growth, is tracked each quarter for 12 quarters after portfolio formation. Such a chart would be of use to us if we wanted to see how well 5-Year EPS growth predicted annual EPS growth for up to 3 years into the future.

What is a good way to look at the performance over time of each of these portfolios, each consisting of a large number of companies? We would like to see both what a “typical” company in each portfolio does, but we also want to get an idea of the overall spread, or distribution, of the companies in each quintile portfolio. And then, we want to compare how each quintile portfolio did against the other four quintile portfolios over time. The Quint Chart above accomplishes all of this in a quick-to-comprehend visual presentation. Let’s take it one step at a time.

What the Top Quintile Tells Us

Let’s start by considering only the top quintile, the group of companies whose 5-Year EPS growth was in the highest 20%. Looking at the chart legend at the top right, we see that this quintile, Q1, has been assigned the color red. (The company group TOP is not a quintile, but is the top 2% of companies, which is interesting to see in addition to the quintiles.)

Bars: 20-80 Percentile Ranges of Company Performance In Each Portfolio

Starting with the date the portfolios are formed and for each of the 12 quarters following we see a group of colored vertical bars, 13 bar groups in all. Each group of bars shows some key information about all the portfolios’ performance that quarter. In each group, the red bar shows data about the top quintile, the yellow bar about the second quintile, and so on (and the magenta bar about the top 2%). To make it easy to see both changes and similarities from quarter to quarter and between the portfolios, each group of bars is structured the same way across the chart.

The red vertical bars tell us about the top quintile portfolio. The bar shows the range from the 20th to 80th percentile of company performance in that portfolio, the top quintile. That may sound confusing: first we divided companies into quintiles, now percentiles… what does that mean?

There are two separate “binning” operations going on. One is where we use a “ranking function” (5-Year EPS growth in this case) to assign companies into quintiles to make the portfolios. Once the portfolios are made, they stay the same. The other operation happens as the portfolios progress over the following 12 quarters. We use an “evaluation function” (year-over-year EPS growth in this case) to see how the individual companies in each portfolio are doing quarter by quarter. It is this second “evaluation” operation that produces the bars each quarter. What the vertical bars show is how the performance of individual companies within each portfolio varied each quarter.

Now back to the chart. The first group of vertical bars at the left shows data for 0 quarters after, in other words exactly at, portfolio formation. The red bar in the first group extends from a low of about -0.1 to a high of about 0.8. That means that at portfolio formation, within this portfolio of companies, the range of year-over-year EPS growth was such that the 20th percentile was about -0.1 and the 80th percentile was about +0.8.

Dots and Lines: Medians

Each bar also has a bright dot of the same color along it. In this case, the red dot is at about Y = 0.25. The dot is located at the performance of the median company in the top portfolio. The median dots are connected by lines all across the chart.

Quarter By Quarter Results

Now move to the second group of vertical bars, above the value 1 on the X axis. This group shows how the portfolios did one quarter after portfolio formation. The portfolios are unchanged, but the year-over-year EPS growth of companies within each portfolio is a little different one quarter later. The red bar in this group ranges from a low of about -0.2 to a high of about 0.7, and the median is also a little lower, at about 0.2. It looks like on the whole the companies in this top portfolio are starting to show slightly poorer EPS growth only a quarter after the portfolio was formed from the top 20% of all 5-Year EPS growth companies.

Moving further to the right quarter by quarter we see a similar change playing out for the first 4 quarters after portfolio formation. While the range between the 20th and 80th percentile of companies in the top portfolio stays about the same (the height of the red bars), the year-over-year EPS growth within that top portfolio continues to drop. The median year-over-year EPS growth very nearly hits zero in the 5th and 6th quarters, and settles at about 0.1 after 8 quarters.

Looking at the Middle Quintile

We will look at two other quintile portfolios to complete this introduction to the Quint Charts. Both show surprising results that would be difficult to see otherwise. First, let’s look at the middle quintile, Q3. Looking at the legend, Q3 is assigned green. The Q3 bars are astonishingly short for the first 3 or 4 quarters, indicating very low variation in year-over-year EPS growth among the companies in this middle portfolio. Although the median company performance in this middle portfolio starts low, at only about 0.1, it stays almost perfectly constant for all 12 quarters. However, over time, the variation in year-over-year EPS growth increases, shown by the growing height of the green bars.

Surprises From the Bottom Quintile

Finally, we will look at the lowest quintile portfolio. The legend shows that it is assigned black. The black set of bars is by far the most unusual. As expected, the portfolio consisting of the worst quintile of 5-Year EPS growth companies starts off with abysmal year-over-year EPS growth as seen by the position of the black bar among the far left group. It also starts with by far the widest variation in year-over-year EPS growth as shown by the height of the black bar.

However, no other portfolio shows the rapid improvement in year-over-year EPS growth that the lowest portfolio does. 4 quarters after portfolio formation, this bottom quintile portfolio is dramatically outperforming all the other portfolios: the median company’s performance is substantially higher than the 80th percentile companies in all of the other portfolios, and the 80th percentile company in the worst portfolio is improving its year-over-year EPS more than triple the rate of any other portfolio’s 80th percentile company.

By 12 quarters after portfolio formation, things have settled down. To a large extent, all five portfolios show fairly similar performance judging by their medians, and variation between their 20th and 80th percentiles appear to be approaching each others’ as well, although the middle quintiles (2Q, 3Q, and 4Q) continue to have a lower variation than their extreme quintile cohorts over this time period.

A Lot of Information, Rapidly

As can be seen, once the Quint Chart format is understood, a great deal of information can be rapidly gleaned from it. In this case, investment strategies already would appear to suggest themselves — some for conservative investors and some for aggressive investors willing to dig into the details of companies populating the bottom quintile of 5-Year EPS growth.

But, But…

We have not yet defined what the ranking or performance evaluation functions are, or what the numbers on the Y axis mean. We haven’t even defined what the “universe” of companies is that we are analyzing. These issues shall be addressed in following posts.