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January 18, 2016

US Stocks: quality shines through clouds
S&P 500 High and Low Quality Rankings Indexes vs Baa spread

chart

Source: Bloomberg, as of 2/4/2016. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The bottom Line:

  • When optimism rules, it's easy for investors to overlook weak fundamentals in their quest for return.
  • Yet the virtues of quality companies shine brighter when times are tougher—as recent market data makes clear.
  • Oil and commodity prices began declining in the summer of 2014, feeding investor concerns about the global economy.
  • Those concerns were apparent in corporate bond prices, particularly lower-rated corporate debt. The spread between Baa-rated bonds (Moody's lowest investment-grade bond rating) and the 10 year US Treasury yield widened by 138 basis points between June 30, 2014 and February 4, 2016.1
  • Stocks overall failed to impress over the same period—with the S&P 500 generating a modest 0.98% cumulative total return.2
  • Yet stocks in the S&P 500 with the highest quality rankings fared much better—the S&P 500 High Quality Rankings Index generated a cumulative return of +9.63%.2
  • What's more, high quality stocks outperformed low quality stocks by more than 2,200 basis points across that 19 month period, as the S&P 500 Low Quality Rankings Index experienced a -12.69% total return.2
  • In particular, during the market corrections in the summer of 2015 and at the start of 2016–periods marked by increased volatility–high quality stocks held up better, outperforming low quality stocks by roughly 400 and 700 basis points respectively.3
  • What constitutes quality? Good corporate fundamentals, for starters: strong balance sheets, low debt ratios, high returns on invested capital and a history of strong cash flow generation and dividend growth.
  • There are qualitative factors too, such as a dominant position in the industry, a product mix that's in demand or a solid research & development component that helps keep that product mix fresh–factors that may help it maintain pricing power in a low inflation environment.

The chart:

  • The chart shows the difference (spread) between the Moody's Baa corporate bond yield and the 10-year UST yield.
  • It also shows the comparative performance of the S&P 500 High Quality Rankings Total Return Index and the S&P 500 Low Quality Rankings Total Return Index–the values of both indexes were re-indexed to 100 as of 6/30/2014.

1Source: Bloomberg. The spread between Moody's Baa corporate bond yield and the 10 year US Treasury yield was 218 basis points on June 30, 2014 and 356 basis points on February 4, 2016.

2 Source: Bloomberg.

3 Source: Bloomberg. From the close on July 20, 2015 to the close on August 25, 2015, the price of the S&P 500 fell 12.25% and the price of the S&P 500 Low Quality Rankings Index fell 12.88%. Meanwhile the price of the S&P 500 High Quality Rankings Index fell just 8.97%. From the close on December 29, 2015 to the close on January 20, 2016 the price of the S&P 500 fell 10.54% and the price of the S&P 500 Low Quality Rankings Index fell 15.32%. Meanwhile the price of the S&P 500 High Quality Rankings Index fell just 8.42%.


Definitions:

The S&P 500 High Quality Rankings Index is designed to provide exposure to constituents of the S&P 500 identified as high quality stocks—stocks with quality rankings of A- and above. As of February 1, 2016, the S&P 500 High Quality Rankings Index had 130 members.

The S&P 500 Low Quality Rankings Index is designed to provide exposure to constituents of the S&P 500 identified as low quality stocks—stocks with quality rankings of B and below. As of February 1, 2016, the S&P 500 Low Quality Rankings Index had 168 members.

The Standard & Poor's Quality Rankings System attempts to measure the growth and stability of earnings and the dividends record within a single rank, and has been calculated on common stocks since 1956.

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

A basis point is one one-hundredth (1/100, or 0.01) of one percent.

A spread is the difference in yield between two different types of fixed income securities.

BAA is a credit rating denoting a medium grade, moderate risk security.

Moody's Investors Service is a leading provider of credit ratings, research, and risk analysis.


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