By Conrad de Aenlle –
Good companies should be good investments, but there are times when the opposite is true. Unfortunately for holders of blues-chip stocks, this has been one of those times.
Research by Richard Bernstein, a strategist at Merrill Lynch, shows that companies whose stocks receive an A-plus rating from Standard & Poor’s – meaning they have 10-year histories of fast yet stable growth of earnings and dividends – have reached a deep valuation discount to weaker B-minus companies. The discount follows a spate of poor performance by the A-plus stocks, but Bernstein said it might be worth betting on a turnaround.
Although valuation is a “notoriously poor timing mechanism,” high-quality stocks have historically outperformed lower-quality ones 72 percent of the time whenever valuations were “similarly stretched,” he wrote in a report on the discrepancy.
Jim Huguet, president of Great Companies Funds, needs no convincing. His portfolios are skewed toward the classier end of the spectrum. “We’re A-plus-rated guys,” he said. “When we look at what we would consider to be A-rated companies – for example, 3M or General Electric or Procter & Gamble – those are the companies we routinely invest in, and they are trading at a significant discount to their intrinsic value.”
Where Bernstein compared valuations between top-flight companies and lesser rivals, Huguet is comparing blue-chips to their own historic norms. Both exercises show that high-quality companies are cheaply priced. By Huguet’s reckoning, stocks like the three he mentioned, and others like Abbott Laboratories, American Express, Microsoft and United Technologies, are trading at discounts to their true worth of 20 percent to 25 percent on average. All of them are in his portfolios.
Bernstein compiled lists of 13 A-plus stocks trading at large discounts to their five-year average price-earnings ratios and 13 B-minus stocks trading at large premiums to their five-year average P/Es. The first list identifies especially cheap constituents of a cheap group of companies. It is filled with blues-chips like Home Depot, GE, Merck, American International Group and Johnson & Johnson, and companies in a mélange of other industries like Harley Davidson, Fifth Third Bancorp and Illinois Tool Works.
The B-minus stocks are concentrated in energy, including Vintage Petroleum, Tesoro and Forest Oil. There is also a sprinkling of telephone and financial-service companies. One entry is Service Corp. International, which operates funeral homes and which S&P optimistically places in its “consumer discretionary” category.
To Ed Choi, co-manager of the G.M.O. Quality fund, this group is a bunch of dogs having their day of the blues. “We’re confident that that profitability is not sustainable,” he said. “Low-quality companies are low quality because they have poor earnings.” By contrast, he said, high-quality companies have substantial profits “without a lot of volatility, and they have low leverage,” meaning they do not have too much debt on their books. “If you had an opportunity to own a high-quality company at a market multiple or a low-quality company,” Choi said, “you should always take the high-quality company because you’re taking less risk.”
What holders of the B-minus stocks should find ominous is that those share prices have risen at an even faster clip than their earnings, discounting continued strong growth that may never come. Neither Choi nor Huguet owns any of the B-minus stocks. Like Huguet, Choi holds quite a few of the A-plus stocks in his portfolios, including Merck, Johnson & Johnson, Home Depot, Harley Davidson and the retailer Dollar General.
When a stock’s valuation becomes markedly cheaper, there is often a good reason, and the presence of Merck and AIG on Bernstein’s list may raise some eyebrows. Both stocks have been depressed this year as Merck fends off lawsuits over the safety of a once widely used drug and AIG deals with allegations of accounting irregularities.
But Choi cited one other characteristic of high-quality companies: It is hard to knock them off their perch. He said that applied to Merck, but declined to offer an opinion on AIG.
Choi noted, “We think the market is paying historically a very high price for low-quality stocks, and high-quality stocks represent the single most attractive investment in the U.S. equity market at this point.”
Source: International Herald Tribune
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