S&P's Straight-A Roster
Call it the revenge of the tried-and-true. In the market boom of the '90s, many investors ignored long-established stock-market fundamentals, such as dividends and earnings growth, in a mad dash for New Economy riches. But since the tech bubble burst -- and the market's descended into a three-year bear pit -- investors seem to have rediscovered these virtues.
It's about time. According to a study of more than 3,400 U.S. stocks released Feb. 25 by Standard & Poor's, a portfolio of issues with a long-term history of growth in earnings and dividends has outperformed the S&P 500-stock index over a period of the 17 years measured in the study. What's more, the portfolio of stocks studied also provides a cushion in times of slowing earnings growth and increased credit risk.
"Factors such as dividend payouts [during the boom] were generally associated with old-line, mature industries and were shunned as good investment opportunities -- this study shows the opposite is the case," says S&P managing director James Branscome. "Many of those companies [that] consistently increase dividends and earnings would actually have been a better investment opportunity and provided more cushion in an investor's portfolio in an economic downturn."
TOP OF THE CLASS.
S&P's quality-rankings system tracks the growth and stability of earnings and dividends companies over the most recent 10-year period. The rankings range from A+ (the highest designation) through C (the lowest), with a D ranking signifying the company is in reorganization. (They are not to be confused with S&P's credit ratings.) By sizing up a company's fundamentals over such a long period, according to S&P, rankings are not unduly influenced by short-term factors and possible accounting manipulations.
The study, available in full at www.standardandpoors.com, states that a portfolio of stocks with the highest quality ranking (A+) outperformed the S&P 500 by nearly 150 basis points. A portfolio of issues rated A+, A, and A- (the "all-A" portfolio) outperformed issues with lower B rankings by almost 400 basis points.
According to the authors of the study, S&P Managing Director Sandeep Patel and Equity Analyst and Investment Officer Massimo Santicchia, the rankings are correlated with several measures of quality of earnings, including S&P's Core Earnings. The analysis also showed that portfolios of high-quality companies, as measured by the rankings, provide higher returns and lower investment risk. The authors say the risk characteristics of high-quality portfolios are attractive, as they provide full participation in up markets and lessen the pain of market declines.
Patel and Santicchia also found that high-quality companies perform better, in terms of profitability and portfolio returns, when corporate earnings overall are declining and the credit cycle is tightening. That's because of their steadiness of sales growth, level and stability of profitability, size, and lower debt leverage.
A majority of the top-ranked companies are in the S&P 500 Index. Of the 69 A+ companies, 45 are in the S&P 500 (see below), 10 are in the S&P MidCap 400 index, and two are in the S&P SmallCap 600 index.
Financial companies represent almost 45% of highly ranked stocks (A- or greater), followed by consumer discretionary (14%), industrials (12%), and utilities and consumer staples (each at 8%). Currently, 13% of the more than 3,400 U.S. stocks with quality rankings have a score of A- or better.
"We found that not only did they outperform the overall market, but that stocks with high Earnings and Dividend rankings generally trade at higher [price-to-earnings and price-to-book value] multiples," Patel said in the press release that accompanied the report. "We see that this premium is indeed justified by the better fundamentals of these companies."
Another significant finding: Systematic differences in accounting practices among companies with different rankings. Companies with high quality rankings have historically reported lower nonrecurring, special, and extraordinary items than lower-ranked companies. As a result, according to S&P, there's an association between a quality ranking and the difference between reported earnings and S&P's Core Earnings of a company. But S&P said it doesn't intend for this ranking to be an indicator of any degree of accounting manipulations on the part of a ranked company.
"Our research also revealed that earnings growth for companies with high Standard & Poor's Earnings and Dividend Rankings is not correlated with overall corporate earnings and credit cycles. Conversely, earnings growth for companies with low Quality Rankings is more dependent on [favorable] earnings and credit cycles," Santicchia said in the release. "For all these reasons, investors may find these highly ranked stocks to be interesting investment opportunities."
The quality rankings are available through S&P Stock Reports on more than 3,400 U.S. companies. Stock Reports are available through the 120,000 investment advisors and brokers who subscribe to the service, and through investor Web sites sponsored by brokerage firms. They also are available to subscribers of The Outlook, Standard & Poor's weekly newsletter for individual investors.