Now's The Time For Quality

12/14/2009


With the Dow Industrials up 57% since March 9, the average U.S. stock trading in line with historical norms based on trailing price/earnings ratios, and the long-term outlook for the U.S. economy still highly uncertain, the temptation to raise some cash is understandable.

We’re holding 20% to 25% of our equity portfolios in short-term bonds as a hedge, and we’ll be quick to adjust that percentage based on market action and the opportunities available in individual stocks. But, for now, we’re reluctant to raise cash aggressively, partly because our growth-at-a-good-price approach is poised to outperform.

Shares of companies with the worst balance sheets and track records have delivered huge returns since March, while those with the best fundamentals have underperformed the average stock. To some extent this makes sense; shares of the most speculative companies were pummeled in the bear market because they were viewed as the most vulnerable to the credit crisis and related calamities. When the worst-case scenario for the economy was averted, speculative stocks enjoyed the biggest rebounds.

However, as happens with many trends on Wall Street, the shift toward risky stocks appears to have been overdone. Consider the following:

For the top one-fifth of S&P 1500 Index stocks based on scores for Quadrix® Quality, the median Quadrix Value score is 72 — close to the 15-year high of 73 and well above the norm of 54. Quality scores reflect long-term growth rates and returns on assets, equity, and investment. Value scores reflect
price/earnings, price/cash flow, and other valuation ratios.

Based on Quadrix Momentum, which reflects recent growth rates, the top one-fifth of stocks has a median Value score of 69 — the highest in 15 years and well above the norm of 52.

Based on trailing price/earnings ratios, the top one-fifth of S&P 1500 stocks on Quality and Momentum have seldom been so cheap relative to other stocks over the past 15 years. The same is true for the top one-fifth based on returns on equity.

Conclusion

Relative to other stocks, high-quality stocks have seldom been cheaper over the past 15 years. Historically, buying shares of high-quality companies trading at attractive valuations has been a winning strategy. While stocks of nearly all stripes are likely to decline in a sharp market correction, our confidence that quality names will outperform over the next year or two figures prominently in our willingness to hold 75% to 80% of our equity portfolios in stocks. Among high-quality stocks with attractive valuations, top picks include Aflac ($46; AFL), BMC Software ($38; BMC), and Hewitt Associates ($43; HEW).


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