We are now living in unusually uncertain times, rising interest rates and inflation, shortages of everyday goods, and continuing geopolitical uncertainty. This has led to the recent extreme market volatility, significant price declines for many stocks, and the possibility of corporate bankruptcies.
Thus, a critical question is: How does an investor minimize the chances of having her portfolio decimated by holding stocks of companies that could go bankrupt or suffer a long-term price collapse? Fortunately, there’s a class of stocks that has historically shown the ability to minimize the risk of bankruptcy or long-term price collapse – high-quality stocks.
One way to begin to identify ones that may be suitable for an investor’s portfolio is the S&P 500 Quality Index (SPXQUP), which tracks high-quality stocks in the S&P 500 index. It uses a quality score based on factors like return on equity and leverage ratios. There’s also a broader S&P quality ranking system not limited to the S&P 500 index.
In either case, the universe of 3,500-plus actively traded U.S. stocks is reduced to a few hundred for investors consideration. For the broader ranking system, investors need only look at the 300 or so stocks ranked A-, A or A+. Research by S&P Global IQ shows that quality stocks defined this way provide solid risk-adjusted performance through good times and bad.
Over the period from 1996 to recently, the S&P 500 had an annualized return of over 8%, while high-quality stocks returned over 11%. In the five down years during that period (2000-2002, 2008, 2018), high-quality stocks outperformed in all except 2018 when they lost 6.8% versus the S&P’s 500’s 4.4%. Other data for the S&P 500 high-quality stocks is also impressive. It shows that over that period, these high-quality stocks only underperformed the S&P 500 in seven years.
Other research shows that portfolios of A-, A and A+ stocks have partially mitigated losses in certain unfavorable markets. Over the 1987-2010 period, these portfolios significantly outperformed both the S&P 500 and low-quality portfolios (stocks rated B or lower) in times of earnings deceleration, credit risk, and investor uncertainty.
One reason for this is earnings growth for A-, A and A+ stocks outperform portfolios of low-quality stocks in bear markets. The research also shows that while portfolios of these stocks outperform portfolios of low-quality stocks in bear markets, they can underperform in bull markets, while generally matching the S&P 500.
However, even better performance may be gained by adding other criteria. One is further winnowing using Value Line Rankings. Reducing the number of high-quality stocks under consideration by limiting those to ones ranked 1 or 2 by Value Line for timeliness. This means they’re both high-quality and growing earnings faster than the average company. Actual results show that portfolios based on these two criteria can both outperform the S&P 500 in the long term and in bear markets like the 2008-09 debacle.