From the September 2006 issue of Investment Advisor • Subscribe!

Panning for Gold

S&P's researchers believe we may have entered a high-quality rally

Over the last 25 years there have been three distinct cycles of outperformance by high Quality Ranking (QR) companies.The longest of the high-quality rallies lasted over a decade--from May 1981 to December 1991--while the shortest ran from February 2000 to October 2002, a 32-month span.

Standard & Poor's Equity Research Services believes we may have just entered into a fourth high-quality rally. While we can't predict how long this rally may last, a look at the previous cycles and the factors driving the current rotation towards high-quality stocks may provide us with guidance on how we might be able to profit from it.

Defining High Quality

First, let's define what we mean by high and low Quality Ranking stocks. Since 1956, Standard & Poor's Equity Research has tracked U.S. equities with a history of at least 10 years of earnings. We then assign an S&P Quality Ranking to each of them, much like a grade assigned by a schoolteacher, ranging from A+ for the top companies to D for companies in reorganization. The rankings are based first on the stability and growth of earnings over the most recent 10-year period, and then (if the company pays a dividend) on the stability and growth of dividends.

Companies that do not pay dividends generally can get an S&P Quality Ranking of no higher than B+.

S&P has done extensive research on the characteristics of each Quality Ranking group, which has shown that high Quality Ranking companies (those with A+, A, and A- Quality Rankings) have wider and more stable profit margins, lower debt levels, and higher returns on equity capital. High QR companies are also less susceptible to fluctuations in general economic activity, and their earnings growth has a low correlation with the overall corporate earnings cycle.

The businesses of low QR companies (Quality Rankings of B+ and below) tend to be volatile, which limits their access to credit markets. In a high interest rate environment, financial liquidity tightens, limiting the amount of money these companies, which depend on bank loans quite heavily, can borrow. Low QR companies have greater financial leverage, which allows them to be more profitable during times of low interest rates and earnings growth, but also makes their profits more vulnerable to tightening monetary policy and corporate earnings deceleration, like we see now.

Historically, interest rates, earnings growth, and risk tolerance have been the drivers for the performance of both high and low Quality Ranking stocks. According to our research, low QR stocks have flourished during times of high earnings growth and low interest rates. In comparison, high QR stocks have benefited from periods of slowing earnings growth and rising interest rates.

The First Three Cycles

The first of the most recent cycles of high QR stock outperformance lasted from May 1981 to December 1991 (over 10 years). The second was from February 1994 to November 1998 (four years and nine months) and the third lasted from February 2000 to October 2002 (two years and eight months).

The 1981-1991 cycle followed a nearly eight-year low Quality Ranking cycle from June 1973 to May 1981, characterized by small-cap outperformance and driven by very low real interest rates (inflation was higher than nominal interest rates for much of this period). Short-term interest rates peaked (at 16.3% for the 3-month Treasury bill) in May 1981, initiating the high QR cycle.

The 1994-1998 high QR cycle anticipated a peak in short-term interest rates, which occurred in February 1995 (at 5.8%). In January 1994, low QR stocks had risen to the point that forward P/E ratios were equal to forward P/E ratios for high QR stocks. Historically, low QR stocks have traded at a discount to high QR issues on a forward P/E basis. Corporate earnings growth reached a peak in December 1993, and then began to decline. Additionally, there were extremely low levels of perceived risk among investors as illustrated by the CBOE Volatility Index, which bottomed at a reading of 9.9 in December 1993, just below the recent (July 2005) bottom of 10.6, while the spreads between junk bonds and high-quality corporate issues had narrowed significantly.

The 2000 to 2002 cycle anticipated a November 2000 peak in short-term interest rates (at 6.2%). Forward P/E ratios for low QR stocks had moved well above those of high QR stocks for the first time in over 20 years. The spread between junk bonds and 10-year U.S. Treasury bonds had reached a historical low. Corporate earnings growth peaked in March 2000. This cycle coincided with the worst bear market in over 70 years.

Protection in Down Markets

Our research shows that when the market declines, high QR stocks offer significantly less downside risk than low QR stocks. For example, when monthly losses on the S&P 500 Index are larger than 8%, the S&P 500 Index drops an average of 11.2% and the low QR stocks fall an average of 12.5%, while the decline of the high QR stocks is less, at an average of 9.4% (see "In Months When the Market's Down . . . chart, below).

Additionally, when the market (using the S&P 500 as a benchmark) has experienced negative full-year returns, high QR stocks have provided investors with better returns either through positive returns or smaller losses. Over the last 20 years, there have been four instances where the market has had negative full-year returns (see table below for actual returns). The average return for those years was (-11.55%) compared to a (-6.25%) return for an all-A portfolio and a -30.43% return for an all-C & D portfolio. The all-A portfolio outperformed both the market and the C & D portfolio in all instances and twice provided small positive returns. Over the long-term, such protection in down markets is key to growing and preserving investors' wealth.

Where Are We Now?

As of August 1, 2006, second-quarter earnings for the S&P 500 were about 2% above S&P analysts' expectations. Conversely, second-quarter earnings for the S&P 400, a mid-cap index, are in line with expectations thus far while the earnings for the S&P 600, which measures small caps, have come in 5% below expectations.

As a result of what has occurred to date during the second-quarter earnings season, Standard & Poor's Equity Research has increased its full-year 2006 earnings estimates by 0.4%, to 12.6%, for the S&P 500, and lowered its full-year earnings growth estimates for the S&P 400 and S&P 600 to 18.4% (from 18.7%) and 17.0% (from 17.9%), respectively.

In addition to a slowdown in small-cap earnings growth, increasing tensions over Iran and North Korea, and the recent escalation of the Israeli/Hezbollah conflict is helping push geopolitical unrest into the forefront of investors' minds. We believe this turbulence may increase the likelihood of a rotation towards higher QR stocks as it may have lessened investors' risk tolerance. As previously noted, when investors' have a limited appetite for risk, high QR stocks have outperformed.

When examining the quality cycle, we have found the following factors to be most significant in predicting a shift from low QR to high QR issues:

  1. rising interest rates;
  2. extreme highs in investor risk tolerance
  3. slowing corporate earnings growth
  4. high relative valuations of low QR vs. high QR issues.

We believe each of these indicators is currently flashing a warning sign for low QR issues.

Much like the environment that precipitated the 1994-1998 high QR rally, valuations of low QR stocks are at historical highs relative to valuations of high QR stocks in terms of price-to-earnings and other valuation ratios. On a P/E basis, low QR stocks are selling at a premium versus their high QR counterparts. It is also important to note corporate earnings growth is long past its peak (June 2004) and is slowing. All of this is occurring while investors have been discounting the risks in the markets, as the Volatility Index appears to have bottomed in July 2005 and has recently spiked sharply higher, and spreads between junk bonds and Treasury bonds appear to be widening.

What has resulted in 2006 thus far has been a tale of two markets. For the first half of the year ending June 30, low QR stocks significantly outperformed High QR issues: 1.58% for all-A Quality Ranking stocks vs. 8.41% for C & D Quality Ranking stocks (see "Performance of Quality Spectrum" chart).

However, total returns for the first half of the year mask the divergent performance of high and low QR stocks during the first and second quarters. During the first quarter, low QR stocks significantly outperformed high QR stocks (19.30% for C & D QR stocks vs. 2.73% for all-A QR stocks). But the opposite occurred during the second quarter, as the market declined during May and June, and high QR stocks held up better than low QR equities.

What to Do?

Standard & Poor's suggests advisors screen for certain fundamental attributes to identify and invest in high S&P Quality Ranking companies.

  1. High ROIC + Low Price-to-Book: This screen attempts to identify high QR stocks that generate superior return on capital but sell at a reasonable valuation in terms of price-to-book. These companies tend to be mature, established businesses with strong cash flow generation. A large percentage of the portfolio is in the consumer staples, health care and consumer discretionary sectors.
  2. High Yield + High Buyback: This strategy picks shareholder-friendly companies, as they use cash for share buybacks and dividends. Indeed, this is a "value strategy with a quality overlay." It's currently concentrated in financials and consumer staples.
  3. Low Price-to-Earnings + Low Price-to-Free Cash Flow: This screen draws from stocks in the high QR universe. It picks stocks that have very low valuation multiples based on both free cash flow and earnings. Currently, financials dominate the list and homebuilders are also represented in large numbers.

Richard Tortoriello is an analyst with Standard & Poor's Equity Research in New York, and Massimo Santicchia is a portfolio manager and strategist at Standard & Poor's and manages two investment portfolios based on S&P Quality Rankings, which are available on Standard & Poor's Portfolio Advisor. E-mail them at richard_tortoriello@standardandpoors.com and massimo_santicchia@standardandpoors.com.

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