Investing: The Debate Over Quality

In this perilous market, there's a flight by investors to quality. But what makes for a "high-quality" investment?
Daniel Horowitz

This whole flight-to-quality thing is getting boring. Investors have rushed into U.S. Treasuries faster than at any time in memory, sending yields down to almost nothing. Now what? Anyone moving out onto the risk curve in search of returns is finding that the next step is tough, because "quality" has gotten so hard to define.

In the market's traditional vernacular, quality refers to stocks and bonds of large companies that are self-financed, strong enough to pay dividends, and free of debt troubles. This year, the term seems to have myriad interpretations, as finding the right mix of safety and return is harder than ever. Now, it seems, you have to sacrifice too much of either to get the other.

Let's assume you want to ease out of the absolute safety of Treasuries. Normally, the S&P 100 index of mega-companies would be perceived as more stable in a market storm than the Russell 2000 index of small-cap stocks. Over the past year, though, the Russell has outperformed the S&P 100. And the difference has widened since November's market low. Riskier assets have done even better: Junk bonds are up by 18%, and emerging markets by 26%.

Still, plenty of investors remain quality purists. "Over the next several years, high quality is going to win," says Ben Inker, head of asset allocation at GMO, a $107 billion fund manager in Boston. "But when people rush back into stocks, they generally look for higher risk, not 'Oh, I'm so excited to get into Procter & Gamble (PG).'" GMO's U.S. Quality Equity III (GQETX) fund lost 24% in 2008—a full 13 points better than the S&P 500. Cold comfort, perhaps, but losing less seems to be the new winning.

Even the purists, though, are more selective these days. The GMO fund, which requires a minimum $10 million initial investment, has abandoned the troubled financial sector. Instead, it's tilting toward companies with dependable profits and low debt in good times and bad. Inker is so leery of financials that he's steering clear of General Electric (GE). The AAA-rated giant is No. 3 in the S&P 100, but its blue-chip bona fides have been jeopardized by its financial-services arm. Microsoft (MSFT), Johnson & Johnson (JNJ), Pfizer (PFE), and Wal-Mart (WMT) do make the cut.

The quality debate is also evident in changing attitudes toward dividends. Time was, those quarterly handouts were trusty indicators of quality. Now they might be a trap. As stocks have collapsed during the past year, dividend yields have doubled. But in recent months, companies have cut dividends at a record clip, hurting those who dived in expecting a generous payout. "It is a different risk-reward trade-off than dividend investors are typically used to," says Howard Silverblatt, senior index analyst at Standard & Poor's (MHP).

That dividend trap, coupled with higher yields on corporate bonds, means quality seekers are jumping to the fixed-income side of the fence. Some $40 billion in new investment-grade bonds were issued in the week of Jan. 5, the most since May. The more daring, meanwhile, are wading into junk-land. Case in point: Cablevision (CVC) just upped its intended $500 million junk-bond offering to $844 million.

Ultimately, quality in this market is in the eye of the beholder. According to Leuthold Group, small companies have outperformed coming out of 12 of the 15 bear markets since 1932—so that's where the Minneapolis money management firm is looking for quality. And investment bank Nomura (NMR), in contrast to GMO's advice, urges investors to load up on financials.

To sum up, quality is big. Or small. Or domestic. Foreign. Cyclical. Defensive. All this harks back to Diversification 101: You're best off owning a bit of everything.

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