During a runaway bull market, investors can do well buying companies with hazy business models and questionable financials. But when the market gets rough, as it has the past six weeks, quality counts. Since the Dow Jones (DJ) industrial average's May 10 high, and in two prior pullbacks in 2001 and 2002, companies identified as low risk by three major stock research firms fared better than the market averages and far, far better -- as much as 35 percentage points -- than the riskiest sorts.
The lesson? In these volatile markets, trade up to low-risk, high-quality stocks with strong fundamentals and a relatively cheap price. They won't defy gravity: If market forces are pushing stocks down, they're going down, too. But they could lead the way back when the market regains its footing.
Which stocks fit the bill? We asked independent research firms Morningstar (MORN), Standard & Poor's (which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP)), and Value Line to name the companies in their safest category that have the most potential for upward movement. Here's how they identify them:
MORNINGSTAR A profitable outfit may not be a good investment unless it is likely to continue to rack up riches. It needs a "wide moat" around its business, a strong competitive advantage that makes it difficult if not impossible for rivals to encroach.
Morningstar analysts say that Wm. Wrigley Jr. (WWY), a current pick, is a wide-moat company. (The firm classifies companies as having a wide moat, a narrow moat, or no moat at all.) The chewing gum giant, which controls 60% of the U.S. and 35% of the global market, benefits from a low-cost worldwide manufacturing and distribution system. Economies of scale allow it to spend generously on marketing and advertising to maintain its leading position and sustain profitability over the long term.
Morningstar then looks at a company's "business risk," a proprietary analysis that is generated from data gleaned from the balance sheet and income statement.
To get to the stocks recommended in the table, Morningstar applied wide-moat and below-average business-risk qualifications to its 1,768-stock universe and then overlayed "strong buy" status, a five-star analyst recommendation. Analysts give five stars to companies that are selling at a big discount to the value of expected cash flows and that are predicted to reach their target prices in three to five years. Morningstar's online subscription costs $135 per year, or $14.95 a month (morningstar.com; 866 608-9570).
STANDARD & POOR'S When you think of a high-quality company, names that usually come to mind are the likes of Citigroup (C), Johnson & Johnson (JNJ), and PepsiCo (PEP). It just so happens that these outfits get high marks for quality from S&P. "[They] tend to be less vulnerable to increasing interest rates and slowdowns in earnings growth," says Massimo Santicchia, director of portfolio management and strategy for S&P's Portfolio Advisors. The system rates 1,070 stocks from A+ to D on their earnings and dividend growth and stability over the past 10 years. Everything above A- is considered high quality; a grade below B+ puts the stock in the low-quality camp. If the company doesn't pay a dividend, its ranking is capped at B+.
But an A+ alone doesn't merit a buy recommendation. S&P's choices must also get a 5-star (strong buy) rating from an analyst. The Stock Appreciation Ranking System (STARS) rates stocks according to an analyst's forecast of share-price behavior over the next year.
You can buy S&P reports at outlook.standardandpoors.com (800 852-1641) for $35 each. Subscriptions to Outlook Online run $199 a year.
VALUE LINE Unlike Morningstar and S&P, Value Line uses purely quantitative statistics to pick stocks. The system looks at stock price stability over the past five years and at financial strength to create a safety ranking. This ranking, which ranges from 1 (safest) to 5 (riskiest), measures the risk of a stock relative to the 1,700 others in Value Line's universe.
Companies such as Wal-Mart Stores (WMT), Medtronic (MDT), and Goldman Sachs (GS) passed the safety test with rankings of 1. To make the ranking, they also must have strong expected price performance relative to the rest of the Value Line universe during the next 6 to 12 months. This second metric, called timeliness, ranges from 1 (which means that it's one of 100 stocks that Value Line expects to outperform the lower-ranked stocks in its universe) to 5 and is based on 10 years of earnings data. Stocks highlighted in the table have a safety rank of 1 and a timeliness rank of 2 or better.
Value Line charges $598 a year for its weekly print publications, which includes online access. It's $538 for the online version alone (valueline.com; 800 833-0046).
By Toddi Gutner