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Low Quality's Round Trip

The bubble in low-quality stocks is the third to deflate

William Hester, CFA
December 2008
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In October of 1927, two years prior to the stock market cash, Coca-Cola CEO Robert Woodruff sensed the market was headed for a fall and that it would take his own company's shares with it. So he quietly bet half of his fortune on a decline in Coke's share price. He was right about the market, but wrong about his stock. On the day of the crash the shares stood at $137, slipping to just $128 at the close. By the end of the year the shares had recovered to $134, and would continue to head higher. By the time Woodruff covered his short position the bet against Coca Cola would end up losing him $400,000 and almost cost him the company, according to Mark Pendergrast's For God, Country and Coca-Cola.

Even in its formative years Coca-Cola was a high quality company. Strong sales growth in the 1920's allowed Woodruff to retire all of the company's preferred stock, leaving the company debt free. The free cash flow the company generated built a strong equity base heading into the stock market crash and the ensuing economic downturn. These characteristics allowed the shares of Coca-Cola to hold up relatively well during the broader stock market decline that followed.

High quality companies have a way of making it through stock market declines in relatively better shape than the average stock - especially when stocks are uniformly overvalued prior to the decline. That can also be said for this decline. Coca-Cola's shares are down 20 percent since the market's peak last year, while the S&P 500 has declined 44 percent during the period. A broader selection of higher quality stocks are also holding up better than the market benchmarks.

The same can't be said for low quality stocks, which have been taking a drubbing. But before we discuss the performance of low quality stocks during the bear market, we need to look at the period leading up to the market's peak. Simply put, from 2003 to the early part of 2007 there was a bubble in low quality stocks. It didn't capture the headlines the way the housing bubble and credit bubble did. But it was equally as impressive. The graph below shows the performance of portfolios of stocks ranked by S&P's quality rating. The rating is based on the stability of earnings and dividends over the prior decade. The ranking gives higher ratings to companies with dependable and stable earnings per share and dividend payments. Companies with less dependable and more cyclical performance receive lower quality ratings.

The difference in the performance between the groups over such a short time is dramatic. The return of the average low quality stock was more than double the return of the typical higher quality stock. Keep in mind that these portfolios were built using only the quality rating. No valuation criteria were applied, no price performance criteria, and no fundamental analysis outside of the company's rating. To outperform the market during these four years you simply had to purchase the companies with the most erratic and least dependable operating performance. Rank companies by quality, and start buying from the bottom of the list.

The graph also shows how difficult it was for investors who held higher quality companies to keep up. The higher the quality rating the more likely it was that the stock's performance trailed the market during this period.

The graph below extends the performance to bring it up to date. The blue line tracks the performance of portfolios of high quality stocks (with a rating of A or better). The red line tracks portfolios of low quality stocks (with a rating of C or worse). The average low quality stock has now given back all of its gains from the previous 4 years, and the group now trails high quality stocks over that period.

This data fits well into the longer term performance patterns of high and low quality stocks - even if it's more pronounced in the current case. Based on a study that S&P performed using market-weighted portfolios of high and low quality companies, they found that high quality companies have outperformed both the market and lower quality companies over the long term. High quality companies outperformed the S&P 500 by 110 basis points annually over the 19-year period through the end of 2004, according to S&P's research. High quality companies outperformed lower quality companies by almost 300 basis points annually over the test period. Higher quality companies also had a lower volatility of returns, had lower betas, and more favorable risk-adjusted returns.

Much of the long-term outperformance of the high quality companies comes from their ability to hold up in down markets. Low quality's underperformance comes mostly from the shellacking they take during bear markets. The graph below shows the performance year to date of the typical stock grouped by quality rating.

The graph shows how widespread the declines have been this past year, no matter the quality ratio of the company. Companies rated A and A- have together fallen by more than 40 percent. That kind of performance provides little solace. But look at the performance of companies with the lowest ratings. Companies rated B- have fallen by almost 60 percent. Companies rated C have fallen by 75 percent.

The decline in low quality stocks is the third full reversal of bubble-like returns during the last bull market. Both housing stocks and companies that built their business on the benefits of leverage have also come full circle. And they're not the only investments that have given back all of their gains since 2003. At the market's low, so had the S&P 500. Noteworthy are the losses that each group incurred to get back to their respective starting points. The graph below shows the percentage change in the Bloomberg Homebuilders Index (in blue), the AMEX Securities Broker/Dealer Index (in red), and portfolios of low quality stocks since 2003. The homebuilders Index has fallen 85 percent peak to trough. The Broker/Dealer Index is down 80 percent. Portfolios of low quality stocks are down by more than 70 percent.

At the recent lows, the S&P 500 was down by 50 percent, and the bubble groups - including home building, leveraged businesses, and low quality companies - have declined by more than 70 percent. This wide performance spread is similar to market's the experience during the 2000-2002 and 1973-1974 market declines.

In 2000 the most loved and overvalued part of the market was technology. During the bear market the NASDAQ Composite Index fell 78 percent. The NASDAQ 100 fell 83 percent from peak to trough. At that point, the overall market had fallen by almost 50 percent.

Another two-tiered market was 1973-74, where investors were told to buy 'one-decision' stocks - those stocks you could buy and hold forever. While the bulk of the Nifty Fifty stocks fell by about 50 percent during those two years, there were exceptions. Using month-end prices, American Express fell by 71 percent, Disney declined by 76 percent, and Avon - a stock with one of the highest P/E ratios in 1973 and one of the favorites of the Nifty Fifty group - fell by 85 percent.

In both cases, the market declined by about 50 percent and some of the most previously loved stocks fell by greater than 70 percent. Though the market quickly moved higher in 2002 and 1974, this doesn't provide much of a case that the market will do the same in this instance. Even so, it should be reassuring to long-term investors that they don't need to chase low-quality stocks or speculative favorites to be successful. Over time, low quality investing tends to be an unrewarding and high-risk round-trip.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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