Quality Time?

S&P thinks stocks with solid track records are suitable for this period of uncertainty

From Standard & Poor's Equity Research

Nothing gives the market cold sweats like uncertainty, and nothing, it would seem, fogs future visibility more than geopolitical disturbance. S&P chief investment strategist Sam Stovall recently looked at the market's response to six shocks: Pearl Harbor, the Cuban missile crisis, the Kennedy assassination, Iraq's invasion of Kuwait, September 11, and the 2004 Madrid bombings. On average, the S&P 500 fell 2.9% on the trading day after these events, from a low of 1.1% (the Kuwait invasion) to 4.4% (Dec. 7, 1941). The S&P's 1.3% price decline on July 12, when investors digested the news that Hezbollah terrorists had kidnapped two Israeli soldiers and that Israel had responded with an air/land/sea assault, is in line with historical norms.

But markets are amazingly resilient in the face of unanticipated shocks. Excluding Pearl Harbor, Stovall found, the S&P 500 was trading at new highs a mere 15 days after the event (55 days including Pearl Harbor). Is it because investors, in aggregate, realize that the forces of the free market will always triumph over radical utopians?

Yet, what markets dislike even more than geopolitical uncertainty are more commonplace disturbances -- above-trend increases in the price of macaroni and cheese; fewer back-to-school clothing purchases; funds once targeted for a new PC spent on the electric bill. Inflation, higher energy prices, and slowing profit and gross domestic product growth are more harmful to markets than any Axis of Evil. Concerns over this trifecta, of course, hold sway now, and S&P's Equity Strategy team has been advising caution and a defensive strategy.

How best to play defense? In his 1934 classic The Intelligent Investor, Benjamin Graham recommended that the average investor buy reasonably valued stocks of large, prominent, conservatively financed companies with long records of continuous dividend payments. Graham -- a giant among "value" investors -- was essentially recommending stocks of companies that S&P would assign a high Quality Ranking (QR) -- those with long records of stability and growth in earnings and dividends. Over time, high-QR companies offer better total return than their low-QR counterparts, and with less risk, according to S&P analyst Richard Tortoriello.

Although high-QR stocks outperform over time, low-QR stocks also have periods of strong outperformance. S&P found that these cycles are correlated to short-term interest rates, with high-QR stocks beginning to outperform as interest rates peak and low-QR stocks beginning to outperform as rates bottom. Tortoriello says that with short-term interest rates likely nearing a peak, and corporate earnings growth slowing down, warning signs are flashing for low-QR issues. Also, valuations of low-QR vs. high-QR issues are at historical highs, and while investors' risk tolerance has pulled back somewhat, it's still at very high levels. This may be a good time to consider adding some stocks with high Quality Rankings to your portfolio.

Most investors associate high-QR stocks with large-caps. But there are more than a few mid-cap and small-cap issues with above-average Quality Rankings, as seen in the table, below. These stocks are also ranked four or five STARS by our analysts, and are diversified among sectors.

  Recommended High-Quality Small- and Mid-Cap Stocks
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