Fuel for 2004's Rally: Quality

After shakier shares took off in '03, S&P says outfits with stronger track records will likely shine as the bull enters Year Two

By Sam Stovall

During 2003, many analysts were scratching their heads over why the shares of companies with very shaky fundamentals significantly outperformed those whose outlooks were very solid. The answer, which initially may sound counterintuitive, is actually quite logical: The year marked the beginning of a new bull market.

In the first year of a new bull market, investors tend to regain their optimism toward the economy and stock market as a whole. That could explain why the S&P 500-stock index has gained an average 38% during the first year of a bull market since 1942. The index' 34% rise from October 9, 2002, through October 9, 2003, plus its 26% gain for all of 2003, is consistent with past performances.


  Since bull markets start amid periods of bleak financial prospects, as well as recent share-price dives, it seems logical to assume that skeptical investors would prefer to venture back into the sea of stocks aboard issues with watertight fundamentals. However, investors are more frequently attracted to borderline companies that were "priced to go out of business" but didn't, since they now offer a greater opportunity to make up for lost ground.

The chart below illustrates this point using S&P's earnings- and dividend-quality rankings, which grade a company's 10-year track record of earnings and dividend increases. A ranking of B+ is average. During 2003, companies with lower-quality rankings (B, B-, and C) posted full-year price advances of 51% to 117%, while the companies ranked A- or better gained less than 31%, on average.

Yet these single-year performances were inconsistent with the average advances for the various quality rankings from 1985-2002. Over this longer term, history has shown that investors have been more willing to bid up the share prices of companies with a consistently strong track record of earnings and dividend increases.


  What of 2004 -- Year Two of the current bull run? S&P believes investors will begin to refocus this year on the shares of larger-cap and higher-quality companies, as they have following first-year bull markets in the past.

To help get a feel for which segments of the market offer the highest average-quality rankings, take a look at the table immediately below, which shows the average-quality ranking in descending order for all companies in the sectors within the S&P 1500 Composite Index and the proportion of companies in the sector that have no quality ranking (usually since they have less than 10 years of earnings and dividend history).

Highest average quality rankings, by sector
Sector Avg. Quality Rank % of Cos. Not Ranked
Consumer Staples A- 14%
Financials A- 20%
Consumer Discretionary B+ 17%
Industrials B+ 17%
Utilities B+ 2%
Energy B 10%
Health Care B 32%
Materials B 15%
Telecom Services B 12%
Information Technology B- 32%

You can see that consumer staples and financial-services companies offer the highest average-quality rankings, while outfits in telecommunications and technology have the lowest. In addition, it's interesting to note that at 2%, the S&P Utilities sector has the lowest percentage of unranked companies, while the health-care and technology sectors, with 32% each, have the highest.

One thing to keep in mind is that investment outlooks for companies, industries, and sectors are not based solely on quality rankings. Even though consumer staples and financials have the highest average-quality rank, S&P's sector-weighting committee still favors the consumer discretionary, health-care, and technology sectors, and recommends an underweighting of the industrials, telecom services, and utilities sectors.

Industry Momentum List Update

For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of Jan. 9.

Industry/Sector Company S&P STARS* Rank
Aluminum/Materials Alcoa (AA ) 4 STARS
Casinos & Gaming/Consumer Discretionary Harrah's (HET ) 4 STARS
Catalog Retail/Consumer Discretionary Insight Enterprises (NSIT ) Not Ranked
Consumer Electronics/Consumer Discretionary Harman International (HAR ) 4 STARS
Diversified Metals & Mining/Materials Phelps Dodge (PD ) 4 STARS
Gold/Materials Newmont Mining (NEM ) 4 STARS
Homebuilding/Consumer Discretionary D.R. Horton (DHI ) 5 STARS
Internet Retail/Info. Tech. eBay (EBAY ) 3 STARS
Internet Software & Services/Info. Tech. Yahoo! (YHOO ) 3 STARS
Office Electronics/Info. Tech. Xerox (XRX ) 3 STARS
Semiconductors/Info. Tech. Intel (INTC ) 5 STARS

* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).

Stovall is chief investment strategist for Standard & Poor's

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