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WSJ - "Junk Stocks" Strut, but Quality Still Matters
Sunday, November 6, 2016

‘Junk Stocks’ Strut, but Quality Still Matters

A rising market and help from the Fed have boosted lower-quality shares, but investment pros question how long it will last

As investors have taken on more risk, so-called quality stocks have in recent months been beaten by their antithesis—so-called junk stocks.

But don’t expect it to last.

Quality on Wall Street generally refers to companies that rank the highest according to measures of financial safety, profitability and growth. Such companies typically also pay a dividend. Numerous academic studies have documented that the stocks of such companies have, over the long term, significantly outperformed the so-called junk stocks at the opposite end of the spectrum. (The most-cited of such studies was by researchers at Greenwich, Conn.-based AQR Capital Management, “Quality Minus Junk.”)

Not this year. Take Walt Disney, the entertainment giant, which many consider to be a “quality” company: It has a long and consistent record of turning a profit, pays a handsome dividend and sports an S&P Quality Rank of A-plus. This year through October, Disney’s stock lost 11.1%, even after taking dividends into account, in contrast to a 5.9% gain for the S&P 500.

At the opposite end of the quality/junk spectrum, in several ways, is Autodesk, the computer-aided-design company. It lost money in fiscal 2016, is projected by FactSet to lose even more in fiscal 2017 and pays no dividend. Its S&P Quality Ranking is C, the lowest. Its stock has nonetheless has risen 18.6% this year.

Quality counts

To be sure, not all quality stocks have lost money this year, just as not all junk stocks have risen. But Disney’s and Autodesk’s experience isn’t unique. Junk’s recent superiority has been particularly evident among smaller-cap stocks, such as those represented by the Russell 2000 index. According to Len Haussler, co-founder of Cincinnati-based Opus Capital Management, companies in this index that are losing money gained 7.1 percentage points more in the third quarter than the profitable ones.

There are two reasons why investors nevertheless shouldn’t give up on quality. The first: Quality stocks’ performance relative to junk tends to be the highest when the broad market is falling, according to Andrea Frazzini, one of the authors of the seminal AQR study on quality and junk; he is an adjunct finance professor at New York University and a principal at AQR. It therefore is hardly surprising that junk recently has beaten quality, he says, because bull-market conditions have largely prevailed.

During the 2007-09 bear market, however, quality stocks on average beat junk stocks by more than 20 percentage points, according to AQR data. They beat them by more than 50 percentage points during the 2000-02 bear market that came as the Internet-stock bubble was bursting.

The second reason not to give up on quality stocks: Such stocks currently have far lower valuations than do junk stocks. So in betting that quality will outperform junk, you also are betting that cheaper stocks will beat more expensive ones.

The Fed’s doing

How cheap are quality stocks right now?

One measure comes from Steven DeSanctis, a small-cap and midcap-focused equity strategist at Jefferies, the New York-based investment-banking firm. He defines the quality category to include the 20% of stocks with the highest return on equity. He says that, relative to the 20% of stocks with the smallest return on equity, the average quality stock’s price-to-sales ratio is lower today than at any time since mid-2000. That earlier time, of course, was when the stock market was just beginning to work off the excesses of the internet bubble.

Both Mr. Haussler and Mr. DeSanctis say the Federal Reserve’s quantitative-easing program is largely to blame for quality stocks being so cheap. They argue that the Fed’s monetary stimulus in effect promotes risk taking and thus reduces quality stocks’ attractiveness. Since both advisers believe that risk could rear its head at any time, they recommend that we not only stick with quality stocks but consider even increasing our investments in them.

In fact, you would want to give up on quality only if you think that the economy and the stock market have hit a “permanently high plateau,” to quote the famous words from Irving Fisher, the 1920s economist who made this fateful prediction just weeks before the 1929 stock-market crash. Otherwise, history teaches us, over any complete cycle encompassing both a bull and a bear market, quality stocks will handily beat junk stocks.

Finding quality

One of the easiest ways to invest in a diversified basket of quality stocks is via an exchange-traded fund. Two of the larger such offerings are iShares Edge MSCI USA Quality Factor (QUAL), with an annual expense ratio of 0.15%, or $15 per $10,000 invested, and PowerShares S&P 500 Quality Portfolio (SPHQ) with a 0.29% expense ratio.

You’ll have to do a lot of legwork if you’d rather invest in individual quality stocks, since you need to analyze and compare a large number of companies according to a host of different metrics.

Here are the five smallest-cap stocks within the S&P 500 that rank above-average in terms of returns on assets, five-year growth rate on return on assets and dividend payout rates—and that are below average in terms of market cap, price-to-book ratios and five-year betas: Avery Dennison (AVY), Darden Restaurants (DRI), Kohl’s (KSS), H&R Block (HRB), and Leggett & Platt (LEG).

From The Wall Street Journal,
by Mark Hulbert



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  Michael R. Knapke
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