following research report was published in Jan. 2005.
StockDiagnostics.com, a subscription-based independent equity research provider
for retail and institutional investors, conducts quantitative research for
a universe of 14,000 stocks, with current buy recommendations for less than
300 stocks. StockDiagnostics.com is a wholly owned subsidiary of Newsgrade
Incorporated, an international news organization. The mission statement of
the StockDiagnostics is to develop a financial service, which analyzes cash
flow statements of thousands of small companies, whom get very little coverage
from the major firms.
Newsgrade Inc., the parent company, was founded in 1996; StockDiagnostics.com
is now in the rollout phase. The main focus of the company is to rank international,
as well as domestic shares on a consistent basis. At the heart of the analysis
is a measure called "operational cash flow per share" (OPS) and the metrics
surrounding the valuation of shares using cash flows, rather than reported
earnings. The Company's senior management team includes:
||Chief Executive Officer
||Chief Financial Officer
||Director of Research
StockDiagnostics.com has two levels of clientele, including retail and institutional
accounts. The internet-based retail product costs $29.95 per month, but including
all the available add-ons, the retail service can run as much as $100 per month.
The retail service ranks the stocks into 8 categories, with stocks in category
1 ranked highest and stocks in category 8 ranked lowest. The company also publishes
a retail newsletter. The institutional product called StockDiagnosticsPro,
costs $30,000 per year, and includes complete access to StockDiagnostics.com's
databases. A custom-designed "Select List" aimed at producing high Alpha /
low Beta results is also available at a minimum cost of $100,000 per year.
The analytical process for developing recommendations is quantitative in the
sense that the analysis covers a huge number of stocks meeting specific criteria.
However, the analysis is fundamental in so far as it defines the characteristics
covered by the analytical algorithms.
StockDiagnosticsPro metrics and the "Select List" have been developed over
a number of years and are rooted in free cash flow analysis, most of which
has been developed by Richard McLean, the Director of Research. Since the value
of a company is simply the present value of its expected future cash flows,
looking at operating cash flows is clearly warranted. Indeed the system is
agnostic in the sense that it defines success based on the cash flow characteristics
of the firm only. The presentation of the cash flow data in an easy to understand
format is one of the major strengths of StockDiagnostics.com. For a more detailed
discussion, see section IV.
StockDiagnostics.com Inc. is headquartered at 811 N.E First Street, in Fort
Lauderdale, FL 33304 and has employees 12 employees, with two thirds of the
staff working in IT / Research. The company Website is www.StockDiagnostics.com.
In examining the business strength of StockDiagnostics.com, it is impossible
to separate the parent (Newsgrade Incorporated) from the sub, since both components
fit into the same business plan, information platform and developmental strategy.
Since its inception in 1996, Newsgrade has raised $18.0 million in capital
and has a total of 400 shareholders. One cannot criticize the management for
thinking too small, given that they have their sights set on rivaling Dow Jones,
Reuters and Bloomberg by becoming a highly regarded newswire throughout the
world. StockDiagnostics has emerged with a compelling research product, which
is arguably completely severable from the parent.
|Estimated 2004 Revenue
||Less than $1.0 mln
|Estimated 2004 Operating Margin
|Estimated 2004 Revenue Growth
Given the relatively large upfront investment and aggressive strategy, it
is encouraging that the company is generating positive earnings already. Despite
the rapid growth and solid profit margin, the company's overall revenue of
less than $1.0 million is relatively small even in the independent research
industry. The extent of automation and small staff leave little concern as
to the controllability of the company's expenses going forward. As management
indicates, the current stage in the roll-out is to develop a top-flight institutional
sales team, and to ramp up revenue from institutional clients. At present,
70% of revenue is being derived from retail clients and the other 30% from
buy-side clients. Given that the institutional product has only been in existence
since November 2003, the penetration into the buy-side is fairly impressive
Unlike other independent research providers, which typically have distribution
agreements with third party distribution platforms, StockDiagnostics' strategy
is to distribute over the Newsgrade platform. This arrangement, if successful,
will boost margins substantially, though we note that the vision is quite ambitious.
The pursuit of both investment analysis and distribution substantially increases
both the expected return and the risk of this venture.
The pricing structure for clients is well within the norms of the industry,
with the retail component being priced at $29.95 for the basic product and
up to $100 for the full retail service per month. As for the institutional
product, the $30,000 per annum subscription fee is also consistent with other
institutional products Integrity research has reviewed. For the custom-designed "Select
List" the price is $100,000 per year.
In the final analysis, the company's financial strength and stability will
depend upon the ability of management to execute its strategy of establishing
itself as a premier financial analysis product and rolling out a distribution
platform that is competitive with other current distribution platforms, such
as Dow Jones, Reuters and Bloomberg. Integrity Research anticipates that the
introduction of such a platform will be met with stiff competition from the
other platforms in the space, though we note that StockDiagnostic.com is a
fully viable business model independent of Newsgrade.
StockDiagnostics.com takes a quantitative approach to analyzing company financial
health by utilizing screening tools, which rely on pure cash flow metrics,
gleaned through the reconciliation of the Income Statement and Balance Sheet
without including investment or financing activity. The central analytical
premise is that Net Income is an inferior measure of profitability. While not
included in the institutional product, the retail site uses a more simplistic,
but nonetheless effective metrics, Operational-Cash flow per Share (OPS) and
the EPS Syndrome. Using these two measures, StockDiagnostics.com indicates
that it could have predicted the Enron and Sunbeam accounting fiascos (among
numerous others). StockDiagnosticsPro, the institutional site, focuses on Free
Cash flow to determine the true profitability of a company. Under the guidance
of Mr. McLean, the Director of Research, StockDiagnosticsPro has created new
and innovative ways to use free cash in basic fundamental analysis. At the
time of this writing StockDiagnosticsPro had buy recommendations on about 19%
of the S&P 500, about 5% of the Russell 2000 and about 3% of the micro-cap
universe ($50 to $300 Million).
StockDiagnostics.com uses the Cash Flow statements of companies which are
published as 10Ks and 10Qs with the Securities Exchange Commission (S.E.C).
As a result, the database and calculations are updated quarterly immediately
following publication of the S.E.C. filings. The main rationale for using cash
flows to value companies is that the value of a company is the discounted future
cash flows being generated by the company. StockDiagnostics.com goes straight
to the Operational Cash Flow component of the cash flow statement in the company's
S.E.C. fillings to get an accurate measure of actual cash flow. The Cash Flow
statement reconciles the balance sheet and the income statement and is composed
to three basic components: 1) operating cash flow; 2) long-term investment
cash flow; and 3) financing cash flow. By focusing on operations, Stockdiagnostics.com
is measuring the profitability of the core business of the firm in a way that
is resistant to creative accounting techniques.
While Integrity Research would agree that cash flow analysis is a substantial
improvement over EPS analysis, it should be noted that there is no silver bullet
that can detect all accounting high jinks. We note that capitalization of expenses
(e.g. Tyco) and the booking revenue, without commensurate increase in accounts
receivable (e.g. Nortel) are difficult to catch in any accounting or cash flow
StockDiagnostics.com does not provide quarterly earnings estimates for the
companies it tracks, nor does it issue BUY/SELL/HOLD recommendations to its
clients. It divides its coverage universe of about 14,000 stocks into 8 distinct
categories, based upon cash flow characteristics.
StockDiagnostics.com covers the following economic sectors and nearly 10,000
shares as per the following table:
Note: Components do not add to the total because there were 58 Multi-industry
excluded from the category totals while they are included in the grand total.
StockDiagnostics has two classes of clients, retail and institutional. At
present there are about 2500 retail clients and nearly twenty institutional
clients. For the basic retail product the cost is $29.95 per month, but this
can increase to as much as $100 per month, depending on the amount of extras
that the client elects to receive. The institutional product is priced at $30,000
per year, with the custom-designed "Select List" priced at a minimum of $100,000.
In the retail camp, there are two main products, consisting of the OPS Newsletter
and the Internet product. The Internet product is a graphical product, which
includes OPS/EPS diagnostic charts for over 14,000 companies. The institutional
product is StockDiagnosticsPro and includes EPS/OPS analysis as well as the
EPS syndrome analysis, discussed in section III. The institutional product
is published on the web via password-protected access.
The Internet product has an easy-to-use interface, which is primarily graphical
in nature, but which has a substantial amount of information presented in investor
friendly format. The OPS/EPS charts compare these two measures of financial
health, denoting EPS positives in black, EPS negatives in gray, OPS positives
in green and OPS negatives in red. Should the company be tagged as presenting
the EPS Syndrome the quarter will be flagged in pink and the company will cease
to be ranked until such time as the condition is cured.
The sophistication of the analysis coupled with the easy to understand graphic
interface, make this product an excellent tool in stock analysis.
To assess the quantitative performance of the StockDiagnosticsPro "Select
List" a comparison of its highest rated stocks to the exchange index from which
that portfolio was generated was undertaken. While the company has more than
two top-rated lists, two indices were chosen as representative of quantitative
performance. The StockDiagnosticsPro "Select List's" top-rated Russell 2000
stocks were compared to the Russell 2000 index and the company's top-rated
small cap stocks were compared to the small cap index. As mentioned previously,
StockDiagnosticsPro does not issue BUY and SELL calls. Rather, it hunts through
the data for stocks meeting given Cash Flow criteria. The strategy is essentially
one of long-term buy and hold, with changes being made quarterly as the quarterly
filings become available. Since there is no short-selling, the portfolio may
lose money in periods of falling stock prices. Therefore, it is entirely consistent
to estimate the excess market returns as a measure of the ability of the company
to choose the best stocks over time.
Integrity Research has evaluated the results associated with such tests conducted
with the "Select List." For the period of Q1-95 Q4-04, the average annual return
for top rated stocks was 17.4%, compared to the Russell 2000 return of 5.1%.
For the Small Cap universe, the top-rated stocks were up 26.0% over the period,
compared to a 7.5% increase in the small cap index. The top rated StockDiagnosticsPro "Select
List" portfolios outperformed the indices by a healthy margin, outperforming
the S&P 500 by 11.8%% over the entire period, beating the Russell 2000 by 12.3%
and, beating the micro-cap composite by 18.5%.
For both of these comparisons, Integrity Research further divided the data
set into salient trends in the individual indices, in order to test the efficacy
of the valuation methodology in differing market conditions. Below are graphs
of the Russell 2000 and the small cap index, as well as tables of the comparative
returns generated by the StockDiagnosticsPro "Select List" in relation to the
respective indices. The tables and graphs address the performance of the StockDiagnosticsPro "Select
List" portfolio to the Russell 2000 index and an index of 2200 small and micro
cap stocks. All results are based on market cap weighted returns.
Segmentation of the data allows us to evaluate the relative performance of
the top rated StockDiagnosticsPro "Select List" portfolio in varying market
conditions (i.e. through the business cycle). As the above table demonstrates,
The StockdiagnosticsPro "Select List" portfolio beat the Russell 2000 by a
healthy margin over the entire time frame and during each directional episode
over the test period. During the initial bull market, top rated stocks offered
annualized returns of 18.5%, while the Russell 2000 expanded by 15.3%, resulting
in an excess return to the top rated Russell portfolio of 3.2%. While both
the Russell and the top rated portfolio fell during the bear market (from Q1-
00 to Q3-02, the top rated Russell portfolio offered an excess return of 33.9%,
with the top rated portfolio rising 3.8%, compared to a slide of over 30% for
the Russell 2000. In the final bull market, the top rated stocks yielded an
excess return of 3.3%.
For the Small Cap universe, the results are even more impressive. Over the
entire period, the StockDiagnosticsPro "Select List" portfolio produced an
annualized excess return of 18.5% over the ten-year time frame.
During the initial bull market, top rated stocks offered annualized returns
of 14.6%, while the small caps index expanded by 14.4%, resulting in an excess
return to the top rated small cap portfolio of 0.1%. While the small cap index
fell by 26.3% in the bear market, the top rated portfolio expanded by a healthy
30.1%, leading to a massive excess return of 56.4%. Finally, in the second
bull stage of the study period, the small cap index rose 34.4%, while the StockDiagnosticsPro "Select
List" portfolio rose 43.7%, for an outperformance of 9.3%.
Despite the fact that the test period contained a significant bear market
and the fact that the StockDiagnosticsPro "Select List" model is a buy and
hold, longer term approach, the analysis produced substantial excess returns
in comparison to the indices from which the portfolios were extracted. As such,
this methodology underpinned by cash flow fundamentals offers significant value
added for investors.
As is the case with most quantitative research firms, StockDiagnostics' research
team is comprised of a limited number of analysts, led by Director of Research
Richard McLean. The company, however, has made this staffing choice by design
rather than by default. The small analytical staff is complimented by a proportionately
large IT staff. As such, the analysts focus is on the cash flow metrics to
uncover companies that are in excellent shape and those that are vulnerable
to near term problems, while the IT department beds down the specific algorithms
to isolate specific characteristics available in the SEC filings of all companies.
This allows StockDiagnostics.com to cover a vast number of shares with a small
The analysts have an average of 30 years of industry experience per analyst,
as listed in the below table.
||Director of Research
|B/A or B/S
|MA or MS
The analytical staff is comprised 100% of seasoned MBAs. Again, as is typical
of many quantitative research firms.
StockDiagnostics.com should not generate many concerns regarding conflicts
of interest, since it utilizes a rules-based analytical system. StockDiagnostics.com
prohibits all staff from buying or selling any of the stocks they recommend
within 48 hours of originating or changing a rating or recommendation. In addition,
the personnel in the company do not receive any compensation from the companies
it does research on. The company receives 100% of its revenue in hard dollars.
Partly as a result of its quantitative, non-subjective rating and valuation
processes, StockDiagnostics.com has not been particularly proactive in taking
steps to fully comply with NASD Rule 2711 and the Securities and Exchange Commission's "Regulation
Analyst Certification" (Regulation AC). These two regulations try to address
a variety of issues surrounding conflicts of interest for research analysts.
These rules contain, among other things:
A requirement that a statement be included in all research reports indicating
- A prohibition on tying analyst compensation to specific investment banking
- A prohibition on offering favorable research to induce firm business;
- Restrictions on relationships between research departments and investment
banking departments of member firms;
- Restrictions on personal trading by analysts in securities of companies
followed by the analyst; and
- Requirements mandating increased disclosure of conflicts of interest
in research reports and public appearances, such as business relationships
with, compensation from, or ownership interests in the company that
is the subject of the research report.
With regard to public appearances made by research analysts, Regulation AC requires
a broker-dealer who publishes, circulates, or provides, directly or indirectly,
a research report by a research analyst, to make a record within thirty days
after each calendar quarter in which the research analyst made the public appearance
- The views expressed in the research report accurately reflect the research
analyst's personal views about the securities and issuers;
- No part of the analyst's compensation was, is, or will be directly
or indirectly related to the recommendations or views contained in
the research report; or
- If the analyst is unable to make the certifications above, the analyst
must certify that part or all of the analyst's compensation was, is,
or will be directly or indirectly related to the specific recommendation
or views contained in the research report. If the analyst did receive
such related compensation, the statement must include the source and
amount of such compensation, and the purpose of the compensation,
and further disclose that such compensation may influence the recommendation
in the research report;
One measure that is sometimes used as an indicator of potential conflict of interest
is the percentage of stocks that a research firm lists as "sells." Many pundits
suggest that a ratio of less than 20% "Sell" to "Buy" recommendations reflects
a bias that might be consistent with potential conflicts of interest. This, of
course is not a major concern for StockDiagnostics.com, since they make only
implicit stock recommendations, based on the cash flow characteristics of companies
it covers. At the time of writing, the company listed 308 stocks as buys, based
on this criterion.
- A written statement by the research analyst certifying that the views expressed
in each public appearance accurately reflected such research analyst's personal
views about the subject securities and issuers; and
- A written statement by the research analyst certifying that no part
of such research analyst's compensation was, is, or will be directly
or indirectly related to any specific recommendations or views expressed
in any public appearance.
Given that the company has just finished rolling out a substantial new product,
it has no immediate plans to further revamp the product line; there may however,
be a number of ratios added to the product, which focus on the valuation of
fixed income securities. These features would be added to the StockDiagnosticsPro
product and may include a measure of Economic Value Added (EVA).
Rather than considering new product ideas at present, the company is putting
much of its effort into marketing the existing product lines. There are currently
2 marketing and sales positions, 2 administration positions and 8 IT / research
positions at the company. By intensifying the marketing and sales effort and
perhaps staffing up this area, the company can increase its revenue and profit
StockDiagnostics.com is a subsidiary of Newsgrade Incorporated, which is
a newswire covering company information, which sees it's main competition coming
from Dows Jones, Reuters and Bloomberg. Newsgrade's main strategy is to cover
nearly every stock on the planet in different languages. As a result, the StockDiagnostics.com
analysis could be easily transported to cover equities in different countries
based on the same cash flow metrics.
StockDiagnostics.com is considering becoming a Registered Investment Advisor
to better serve it's clients.
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