Stocks: Quality Still Counts

The stock market has gained 58% since its bear-market low Mar. 9, but the rally hasn't lifted all equities equally. As is typical in many market bouncebacks, the worst recovered first. Low-quality companies, those with weak or nonexistent profits, mediocre return on equity, and less-than-stellar balance sheets, outpaced their more solidly profitable peers by nearly a 2-to-1 margin, according to research from Baird Private Wealth Management.

Baird found that companies not earning a profit gained 92% from the Mar. 9 lows through the end of August, compared with a 47% rise for companies that had the highest profit margins. Companies with the lowest return on equity outperformed those with the highest by more than 2 to 1, according to Baird.

But the data also show that this kind of low-quality rally is perfectly normal—and usually short-lived. For one thing, the profit-deficient companies suffered bigger price declines during the worst of the stock market tumult. The companies that were hit the hardest rally the most when it becomes clear they're not going away, but as the market normalizes, the rally will end. "Once this initial burst comes through, high quality emerges," says Aaron S. Reynolds, senior portfolio analyst at Baird.

Buffett and Berkshire May Benefit Quality, however, is in the eye of the beholder. Adviser Steve Shueh of Roundview Capital in Princeton, N.J., is looking for top companies that will benefit as government support of the financial system is scaled back and fiscal stimulus ends—and private investment replaces public dollars. At the top of his list: Berkshire Hathaway (BRKA). Shares of Warren Buffett's holding company are up just 5.9% in 2009, lagging the Standard & Poor's 500-stock index by nearly 10 percentage points. Investors shunned the stock as Buffett loaded up on ConocoPhillips (COP) as oil peaked, his foray into derivatives soured, and Berkshire lost its AAA credit rating.

But Buffett may have the last laugh. Now his preferred-stock investments in General Electric (GE) and Goldman Sachs (GS), which yield 10% annually and can be converted to common stock, look shrewd. Berkshire's insurance business, too, is holding up better than Wall Street had expected. At Geico, for instance, the number of new policies grew by nearly 11%, at a time of industry contraction. Shueh says the company will perform even better as government support is slowly withdrawn from American International Group (AIG) and the insurance market returns to a more normal footing. And Berkshire's shares are trading near 1.4 times book value, at the bottom of its historical range. "Berskshire is a blue chip," says Shueh. "And cheap." (Cheap, of course, in terms of valuation, as the famously high-ticket stock fetches 3,381.00 per "B" share.)

Beaten-down consumer powerhouses may also provide opportunity. Shares of Procter & Gamble (PG), for instance, are down 11% for the year, lagging the S&P 500's 16.5% gain, and its performance has been deserved. During the worst of the crisis, P&G raised prices overseas to compensate for a strengthening dollar, causing some customers to shun its premium offerings. Its lack of value-priced brands didn't help. This quarter, it expects "organic" sales—revenues not including the impact of acquisitions and foreign exchange—to drop as much as 3%. But a turnaround may be in the offing: On Sept. 10, the consumer-products giant announced that those sales should grow 1% to 4% next quarter, sending P&G shares up 4.2%. The abrupt comeback appears to have been spurred by the company's plans to spend as much as $600 million on bolstering its brands and cutting prices. In Turkey, for instance, the company has regained the eight percentage points of market share it lost earlier in the year by cutting prices to reflect the fall in the Turkish lira.

A Pick for a Choppier Market: Unilever At 55.03, Procter & Gamble shares remain cheap even after the recent mini-rally, says UBS (UBS) analyst Nik Modi. Modi expects the company's shares to outperform the market—if P&G can "deliver on its promise [of renewed growth]. And I'm pretty confident they can," he says. The stock should trade around 70 within the next 12 months, Modi says.

Another underperforming consumer giant may be just the ticket for those who think the stock market rally could hit a speed bump. Matthew Berler, a portfolio manager at the Osterweis Fund, expects the market to be choppier going into 2010 and is looking for stocks that will be able to thrive in that environment. One of his top picks for that scenario: Unilever (UL). In the past, the company was plagued by inefficiencies that saw it lag behind the competition. But new CEO Paul Polman has begun to bring focus to the company, which has resulted in better performance, and Morningstar (MORN) analysts expect the Anglo-Dutch giant's profit margins to grow to 16% by 2013 from 2008's 14.6%. Unilever's stock is up 19.3% this year, but Berler believes it has more room to run.

Berler also likes Bayer (BAYRY), which was beaten up with other pharmaceutical names in the sell-off but has a strong drug pipeline, and few drugs going off patent. And no matter what happens—a further recovery or a double-dip recession—the drugmaker should continue to do well. "They're decidedly defensive," Berler says. "But even if the market is stronger than we think, they'll work out just fine."

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