Monday, May 12, 2014

Quality Stocks Serve As A Port In A Storm

One favorable aspect to the highest-quality companies/stocks is they tend to fall less in down equity markets. If an investor then structures their portfolio to loss less when the market does correct, the return needed in a subsequent market rebound is smaller if the loss is smaller. Over a complete market cycle then, if one losses less and stays in the game on the upside, they will tend to outperform the overall market. Incurring significant losses in down markets is what does the most damage to compounding one's portfolio growth.

From The Blog of HORAN Capital Advisors

It is the highest-quality companies that have a positive return profile when the market corrects. Many of these highest quality companies are dividend payers as well. A common "quality" measurement variable is S&P Dow Jones Indices Earnings and Dividend Quality Ranking. I touched on this last week in the post, An Alternative To Selling In May. Additionally, I wrote a post in 2006 covering S&P's Quality Ranking System, Standard & Poor's Ranking System. As a follow up, T. Rowe Price included an article in the Spring 2014 T. Rowe Price Report titled, Highest-Quality U.S. Stocks Outperformed Overall. A couple of factors that came out of the study referenced in the article:
  • "The highest-quality stocks tended to outperform the overall market and the lowest-quality stocks."
  • "These stocks particularly tended to outperform during months in which the market fell by at least 3%."
  • "The lowest-quality stocks tended to outperform the market and the highest-quality stocks during months in which the market rose by at least 3%."
  • "Periods of outperformance of high-quality stocks tended to persist for up to 24 months."
  • "The same general trends were found among stocks in developed and emerging regions around the world."
The outperformance in down markets actually equates to positive returns for the highest quality companies as can be seen in the below chart. In every year the lowest quality stocks generated a negative return, the highest-quality stocks generated a positive return.

From The Blog of HORAN Capital Advisors

One important takeaway from the T. Rowe Price study is the fact the lowest quality stocks tended to outperform after coming out of a recession. I think it is fair to say the current economy is not now just coming out of a recession.

So instead of simply selling in May, focusing on the highest quality companies is an alternative. Keep in mind though, a number of the highest quality companies have experienced strong returns this year, pushing some of their stock valuations to the higher end of their historical ranges. Lastly, Atlanta Capital Investment Managers publishes an in depth quarterly Quality Scorecard Report that can be accessed under "Quality Scorecards" on their publications tab for readers interested in more detail on quality rankings.

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