High Quality Stocks Positioned for a Comeback

While various market cycles share characteristics with one another, each one is unique in its own right. The bear market at the onset of the decade was largely a function of a bubble in technology stocks and a recession driven by a collapse in corporate profits. The recent bear market resulted from the bursting of a credit bubble and the ensuing collapse of housing prices and consumer spending. In the first instance, there were places for investors to hide, namely investment grade bonds and value stocks. Small cap value stocks essentially experienced a bull market from 2000 through 2006 that was briefly interrupted by the terrorist strikes in September of 2001 and the second and third quarters of 2002 when the market’s decline became all encompassing. Large value stocks were up modestly over the two years through 2001, but suffered a double-digit decline in 2002. While they posted annualized losses over the three-year period, the losses were far more modest than those suffered by growth stocks (Chart 1).

Conversely, over the 15 months through March 2009, there was virtually nowhere for investors to hide. The lone exception was the US Treasury market, which posted double-digit returns that propped up the performance of investment grade fixed income markets (Chart 2).

When markets become gripped by fear, as they were from mid-September of ‘08 through their nadir on March 9, 2009, selling often becomes indiscriminate and company fundamentals become meaningfully disconnected from stock prices. Investors become willing sellers at any price, yet there is nary a buyer to be found regardless of how low prices fall. In such circumstance, stocks of companies with excellent management, strong business models, healthy balance sheets, and modest exposure to the economic cycle often decline as much as those that are deeply cyclical or that have poor management, poor business models, and problematic balance sheets.

Standard and Poor’s Quality Rankings are a function of the variability of a company’s earnings and dividend growth over the most recent 10-year period. Companies exhibiting greater consistency in the growth of earnings and dividends receive higher rankings. We reviewed the performance of high, mid, and low quality stocks in the S&P 900 from the first quarter of 2008 through the second quarter of 2010 (The Index is a combination of the S&P 500, a large cap index, and the S&P 400 a mid cap index.). We note that the data compiled omits any company within the benchmark that has not been assigned a quality ranking and that the returns are equally, rather than cap, weighted. As such, the returns indicate the average return of stocks in each quality category. During the first three quarters of 2008, higher quality stocks held up better than lower quality issues. However, as the decline became a rout and the selling indiscriminant, high quality stocks declined much further than their lower quality peers (Chart 3).

It is not unusual for selling to become indiscriminant during a crisis or the capitulation phase of a bear market. Nor is it unusual for the initial leg of a bull market to consist of a “junk” rally, i.e. a rally led by lower quality issues. Troubled and deeply cyclical companies are often market leaders during the initial rally from bear market lows. In this stage of the market cycle, investors are drawn to deeply cyclical companies, whose earnings typically rebound dramatically in the initial stages of an economic recovery. They are also drawn to the shares of companies that are now expected to survive, but which where priced to bankruptcy during the bear market. Neither type of company typically ranks among the highest in quality. The former often have highly cyclical earnings, but may exhibit strong cash flows and a solid history of consistent dividend payments, landing them in the middle tier of quality. The latter are typically lower quality companies, lacking consistency in earnings and dividend growth due to poor management, poor business models, and weak balances sheets that often made them suspect even in healthy economic environments.

What ensued over the final three quarters of 2009 (or more accurately from March 10, 2009 through year-end) clearly qualified as a “junk” rally. High quality issues, having declined more than mid and low quality stocks in the first quarter and rallying less over the subsequent three, massively underperformed for the year (Chart 4).

However, the tide began to turn in the fourth quarter as stocks across the quality spectrum performed in line with one another and then did so again in the first quarter of 2010. During the second quarter correction, high quality stocks held up far better than mid and low quality issues. As a result, while stocks were down year-to-date across the quality spectrum through June, high quality issues were down far less than their lower quality peers (Chart 5).

We believe that high quality stocks are in the early stages of a period of long-term outperformance. Over the last two and a half years, high quality issues have underperformed mid and low quality stocks by approximately 24 percentage points, or nearly 9% on an annualized basis. While high quality issues entered 2008 trading at a discount to lower quality stocks, that discount has widened measurably. Lower valuations, coupled with greater stability in earnings and dividend growth, make them more attractive than their mid and low quality peers. In fact, we would argue that high quality stocks are the only truly undervalued segment of the domestic equity market. Additionally, the greater predictability of their earnings should be even more attractive in what remains a highly unpredictable economic environment. High quality stocks are likely to have more limited downside risk, greater upside potential, and far better risk-adjusted performance over the subsequent three to five years than lower quality issues.