For decades, I have advised my monthly strategy report subscribers to invest in stable companies with entrenched competitive positions, strong balance sheets, and a history of paying dividends. Many of the stocks I advise are considered high-quality stocks. What is a high-quality stock? There are varying definitions of quality. Standard and Poor’s generates quality rankings for stocks based on the growth and stability of earnings and dividends. Others include measures of debt and returns on capital. Most investors would consider stocks with consistent earnings growth, strong balance sheets, and strong returns on capital to be high-quality stocks. Companies such as Johnson & Johnson and Coca-Cola would fall into this category. Low-quality stocks are those companies with volatile earnings streams, excessive leverage, and below-average returns on capital. Think homebuilders or commodity chemical companies.
Historically, high-quality stocks have traded at a premium to low-quality stocks. Why? High-quality stocks are less risky than low-quality stocks. Consequently, they have been priced at a premium to deliver lower prospective returns than low-quality stocks. But today, high-quality stocks are cheaper than low-quality stocks. According to Jeremy Grantham, a Boston-based institutional money manager, high-quality stocks are priced to produce returns that are 2.3X greater than those forecasted for the S&P 500. The inquisitive investor might want to know why high-quality stocks are so cheap compared to low-quality stocks. There is of course no factual answer to that question, but one reason high-quality stocks may be cheaper than low-quality stocks is that in recent years investors have shifted their asset allocation away from stocks. Boomers are selling equities to buy more bonds and pension funds, and endowments have aggressively moved into alternative asset classes. Since both of these investor groups tend to favor blue-chips in the equity component of their portfolios, the selling pressure could be disproportionately weighing on high-quality stocks. When the crowd is moving in one direction, successful investors head the other way. You want to do the same. High quality stocks offer an attractive entry point today.
