Stocks: Stability Is Sexy Again

S&P's Richard Tortoriello says conditions are ripe for investors to shift from riskier names to outfits with solid earnings and dividends records

For the last few years, investors have flocked to commodities, energy, real estate, and small-cap stocks -- anything but the U.S.'s stable blue chips (see BW, 4/17/06, "Blue Chip Blues"). But the tide is ready to turn to high-quality stocks -- those with long-term growth and stability in earnings and dividends, says Standard & Poor's equity analyst Richard Tortoriello. The reasons: Interest rates are nearing a peak, earnings growth is slowing, and valuations of riskier low-quality stocks are starting to find themselves stretched.

In a study he recently co-authored for S&P Equity Research, Tortoriello found that over the long term, stocks of companies with a high S&P Quality Ranking (QR) -- which measures consistency of earnings and dividends growth over the last 10 years -- outperform both low-QR stocks and the S&P 500-stock index. However, the riskier low-QR stocks have been outperforming high-QR stocks since October, 2002. This showing has caused stocks with a high QR to trade at a discount to their low-QR counterparts, vs. a historical premium, he says.

The S&P Quality Ranking constitutes just one measure of a company's health. Companies that score a high QR as well as a strong buy recommendation from S&P's analysts include Automatic Data Processing (ADP), Citigroup (C), Colgate-Palmolive (CL), Home Depot (HD), Johnson & Johnson (JNJ), PepsiCo (PEP), Wal-Mart (WMT), and Wrigley (WWY).

BusinessWeek Online's Karyn McCormack recently spoke with Tortoriello about why he thinks investors will shift back into high-quality companies, and which ones earn a high grade from S&P. Edited excerpts of their conversation follow.

Note: Richard Tortoriello is a Standard & Poor's Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this story.

You predict that investors will shift from more risky stocks that have been outperforming to high-quality ones. Why?

Historically, investors have shifted to less risky assets as short-term interest rates have peaked. Higher interest rates increase risk to the economy. Profits can suffer, and bankruptcy risk for some companies goes up. Also, at some point, valuations of low-quality companies become high relative to those of high-quality companies.

We believe we may be near the peak of the current interest-rate cycle with regard to short-term rates. In addition, valuations of low-quality stocks are now at historical highs relative to those of high-quality stocks.

It's worth noting, though, that low-quality companies in general have significantly reduced debt, and with long-term interest rates low and credit relatively easy to get, we don't see much bankruptcy risk.

This is based on a company's S&P Quality Ranking. What is this, and how can investors use it?

S&P Quality Rankings measure both consistency and growth of earnings and dividends over a 10-year period. The ranking was actually invented in 1956, and is used extensively by S&P and others to determine how well a company has performed historically in both good times and bad.

Rankings range from A+, our highest ranking, to C, our lowest. Generally, we consider stocks ranked A+, A, and A- as high quality, and those ranked B, B-, and C as low quality, with B+ being an average ranking.

Just because a stock is ranked A or even A+ doesn't mean that the time is right to buy it. As with all stocks, prices and valuations will fluctuate over time. However, we've also found that high-quality stocks in general have outperformed over time, with lower risk than low-quality stocks.

Which sectors tend to have a higher percentage of high-quality stocks?

Since Quality Rankings are based on 10 years of earnings and dividends, stocks with higher Quality Rankings tend to predominate in economic sectors that don't go up and down with the economy. Consumer staples and health care are two sectors that have a lot of high Quality Ranking stocks. Financials and industrials also have relatively high levels of high-quality companies.

What are some stocks with high S&P Quality Rankings that S&P likes?

A list of A+ ranked stocks that are also ranked 5 STARS, or strong buy, by S&P's equity analysts include Automatic Data Processing, Citigroup, Colgate-Palmolive, Home Depot, Johnson & Johnson, PepsiCo, UnitedHealth Group (UNH), Wal-Mart, and Wrigley.

You've done a few screens of high-quality stocks. Can you talk about one of them and the stocks that turned up?

We do a lot of research on the subject of high-quality stocks. One of the things we do is screen on various fundamental and valuation measures. One screen we did was for stocks with the highest levels of return on invested capital, which measures profitability, and the lowest price-to-book values, which measures valuation.

Four stocks I'd mention in particular that turned up on this screen were Pfizer (PFE), McDonald's (MCD), Ingersoll-Rand (IR), and Masco (MAS). McDonald's is ranked hold by our analysts, Pfizer and Masco are ranked buy, and Ingersoll-Rand is ranked strong buy.

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