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So many investment notions sound plausible, intuitive, even wise, well before the market begins abiding by them. How long, for instance, has the consensus been that Treasury yields should be barreling higher?
One common thought in the equity world has been that a rotation of investor dollars toward shares of "high-quality" companies should be imminent.
This is a sane and sober idea, and one that generally hasn't worked in the past couple of years, when markets have been lifted by improving credit conditions, a snap-back in corporate profits and surging risk appetites. These drivers of market action almost always favor smaller, more volatile, more cyclical and less well-capitalized stocks, which have led this bull market.
There are various ways to define high quality, of course, but most have lagged. The GMO Quality mutual fund, for example, has badly trailed the Standard & Poor's 500 by doing exactly what it's supposed to do -- own mainly mega-cap, financially bulletproof stocks.
Another proxy for the quality sector, the Vanguard Dividend Appreciation exchange-traded fund (VIG), focuses specifically on serial dividend hikers, yet has lagged similarly. This isn't at all a pure income vehicle (the fund yields less than 2%), but is based on the Mergent Dividend Achievers Select Index, which uses steady payout increases as a filter for reliable companies with good balance sheets.
Strategas Research Partners has maintained a quality-stock benchmark for a few years, screening mid- and large-cap stocks using several factors, including price/book ratio, increasing dividends, debt-to-equity ratio and free cash flow. This index had a good run from the start of the spring 2010 correction, but has underperformed the S&P 500 a bit since the summer.
Of course, all these baskets held up better than the market in last week's overdue, sharp, but so far rather shallow decline in the face of rising oil prices and some public caution about Middle East instability. That's what happens in corrections -- defensive stocks give up fewer points than aggressive ones.
So, clearly, anyone betting that last week's hiccup is the beginning of something more ominous ought to huddle in these sorts of names. At this point, the headline-induced selling storm of last week hasn't stripped away the benefit of the doubt that bulls have enjoyed.
For one thing, the credit and currency markets didn't recoil in fear the way they did, say, last year during the European debt drama. And, helpfully, the AAII poll of individual investors showed a marked decline in bullish feeling after only a 3% drop -- a contrarian boost for bulls -- similar to the way the little guy reacted to the fleeting weakness of last November. Since the March 2009 market low, there have been a half-dozen pullbacks of more than 5%, so we can easily get another without badly disturbing the trend, even if bull markets prove less able to shake off such setbacks as they age.
Yet it makes sense to ask if, even in a relatively strong market, the recent penalty some investors have absorbed for favoring quality might at least be diminished.
For one thing, smaller and more cyclically geared stocks are more expensive and have more "air" underneath them than blue chips do. We're unlikely to see dramatic improvement in already-strong credit conditions and general liquidity, things that often fuel low-quality outperformance.
And, while last week's clear inverse relationship between oil prices and the stock indexes made it seem as if macro factors still hold sway, below the surface of the indexes stock-by-stock correlations have declined, which means the reward for discerning better versus worse quality has, for now, been rising.
Finally, the bigger, financially fit companies that make up all those quality benchmarks are those that can best exploit the current financial-engineering phase of the cycle from positions of strength. They have cash for buybacks, the ability to take on leverage, the resources for accretive acquisitions, the capacity for opportunistic expansion and the freedom to spin off businesses that don't fit. Last week saw such companies as Danaher (DHR), Thermo Fisher Scientific (TMO) and Target (TGT) pursuing one or another of these tacks.
Credit Suisse's quantitative-strategy group Thursday took a fresh angle on the quality trade by studying what sorts of dividend policies have led to the best stock performance since 1995. It turns out that for most industry sectors, having a higher-than-average dividend yield while paying out a lower-than-average portion of earnings was the best group. Stocks with these characteristics, which neatly fit the quality-stock theme, include Comcast (CMCSA), Time Warner (TWX), Target, Eli Lilly (LLY), 3M (MMM) and Boeing (BA).
E-mail: michael.santoli@barrons.com
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