Yet Another Plug for U.S. Quality Stocks

Our main argument is quantitative. Quality stocks (high, stable return and low debt) simply look cheap and have gotten painfully cheaper as the Fed beats investors into buying junk and other risky assets, a hair-of-the-dog strategy if ever there was one.

In our seven-year forecast the quality segment has a full seven-percentage-point lead per year over the whole S&P 500, or 9% over the balance ex-quality. This is now at genuine outlier levels.

In addition, there are qualitative arguments. We like owning high-quality blue chips if we are indeed going into a more difficult seven years than any we have faced since the 1970s.

The problems of reducing debt and the potential share dilution that can go with it as it did in Japan for a decade, particularly play to the strength of the largely debt-free high-quality companies.

And for nervous investors there is yet another reason for favoring quality stocks: their more than 50% foreign earnings component, which is higher than the balance of the S&P 500 with its heavy financial component.

In the long run, quality stocks have proven to be the one free lunch: you simply have not had to pay for the privilege of owning the great safe companies, as plain logic and established theory would both suggest.

Quality continues to be a significant theme in our portfolios, as many companies with strong balance sheets that are leaders in their industries areavailable to us in the cheapest quintile of valuation.

This is particularly prevalent in (but not limited to) the technology sector, where companies have low or no debt, and cash balances that would see them through the most extreme business downturn.

 

These businesses typically attract premium valuations, but are now some of the cheapest in our investment universe. We have taken advantage of this unusual opportunity

Conclusion

While market pundits are counseling "de-risking" as their advice du jour, equities in general and value spreads in particular remain attractive despite the sharp run up of the last seven months.

 

History suggests that we are still in the early innings of this value cycle, with the next leg up likely to be driven by earnings increases in the context of a modest economic recovery.

 

We continue to find high quality companies in sectors experiencing near term stress where we believe research and patience are the ingredients for long term outperformance.

Generally speaking, Greenblatt says the value today is predominantly in "higher quality business that didn't get hurt as badly in the recession" vs. the low-quality names like AIG and Fannie Mae which led the rally off the March lows.

 

Among the "beaten up stocks" currently ranked highly by Greenblatt's are construction companies, select retailers and McGraw-Hill.