The significant rise in volatility since the recession and credit crisis began reflects the unusually large amount of uncertainty surrounding the outlook for the economy and corporate profits. Normally, over the course of a few months or quarters, investors are able to gauge how bad things are likely to get. As a result, the market establishes a trough and begins moving upward from there as recovery approaches.
This time, however, the extraordinary problems in the global financial system have meant that severe downside risks to the economy have remained possible for far longer than normal. Those risks have been easing in recent months, but have not disappeared.
Why Quality Stocks?
Several factors have set the stage for high-quality stocks. First, the heightened volatility has caused a flight to quality for both stock and bond investments. In a risk-adverse environment such as this, companies with a more stable track record of earnings growth, lower debt ratios and strong management tend to be seen as less risky and most apt to benefit during a recovery—especially a slow recovery as we’re experiencing now.
In fact, according to Standard & Poor’s, high quality companies have generated a nearly 5% higher return with one-third less risk compared with low quality companies over the past 20 years ending December 31, 2008. Standard & Poor's defines a high-quality stock as one with a record of long-term growth as well as stability in its earnings and dividend payouts.
Second, their low debt and better cash flow also tends to make high-quality stocks more resilient during a period of rising interest rates, which can be expected as the markets work their way through the financial and economic mess.
Finally, the credit crisis has taken a smaller toll on the highest quality companies. Unlike many who have to wait for the credit taps to start flowing again, these highest quality companies have been able to finance growth throughout—and it should become even easier for them to do so in the year ahead.
In challenging times like the present, high-quality stocks could potentially provide some cushion for your portfolio—and may be well-positioned to benefit as the economy and markets recover. Another positive is that they still have relatively attractive valuations.
As for sectors of opportunity, these high-quality companies are well-represented in Consumers Staples and Health Care—as well as Financials and Industrials, to a lesser extent.