Over the last 25 years there have been three distinct cycles of outperformance by high Quality Ranking (QR) companies.The longest of the high-quality rallies lasted over a decade–from May 1981 to December 1991–while the shortest ran from February 2000 to October 2002, a 32-month span.
Standard & Poor's Equity Research Services believes we may have just entered into a fourth high-quality rally. While we can't predict how long this rally may last, a look at the previous cycles and the factors driving the current rotation towards high-quality stocks may provide us with guidance on how we might be able to profit from it.
Defining High Quality
First, let's define what we mean by high and low Quality Ranking stocks. Since 1956, Standard & Poor's Equity Research has tracked U.S. equities with a history of at least 10 years of earnings. We then assign an S&P Quality Ranking to each of them, much like a grade assigned by a schoolteacher, ranging from A+ for the top companies to D for companies in reorganization. The rankings are based first on the stability and growth of earnings over the most recent 10-year period, and then (if the company pays a dividend) on the stability and growth of dividends.
Companies that do not pay dividends generally can get an S&P Quality Ranking of no higher than B+.
S&P has done extensive research on the characteristics of each Quality Ranking group, which has shown that high Quality Ranking companies (those with A+, A, and A- Quality Rankings) have wider and more stable profit margins, lower debt levels, and higher returns on equity capital. High QR companies are also less susceptible to fluctuations in general economic activity, and their earnings growth has a low correlation with the overall corporate earnings cycle.
The businesses of low QR companies (Quality Rankings of B+ and below) tend to be volatile, which limits their access to credit markets. In a high interest rate environment, financial liquidity tightens, limiting the amount of money these companies, which depend on bank loans quite heavily, can borrow. Low QR companies have greater financial leverage, which allows them to be more profitable during times of low interest rates and earnings growth, but also makes their profits more vulnerable to tightening monetary policy and corporate earnings deceleration, like we see now.
Historically, interest rates, earnings growth, and risk tolerance have been the drivers for the performance of both high and low Quality Ranking stocks. According to our research, low QR stocks have flourished during times of high earnings growth and low interest rates. In comparison, high QR stocks have benefited from periods of slowing earnings growth and rising interest rates.
The First Three Cycles
The first of the most recent cycles of high QR stock outperformance lasted from May 1981 to December 1991 (over 10 years). The second was from February 1994 to November 1998 (four years and nine months) and the third lasted from February 2000 to October 2002 (two years and eight months).
The 1981-1991 cycle followed a nearly eight-year low Quality Ranking cycle from June 1973 to May 1981, characterized by small-cap outperformance and driven by very low real interest rates (inflation was higher than nominal interest rates for much of this period). Short-term interest rates peaked (at 16.3% for the 3-month Treasury bill) in May 1981, initiating the high QR cycle.
The 1994-1998 high QR cycle anticipated a peak in short-term interest rates, which occurred in February 1995 (at 5.8%). In January 1994, low QR stocks had risen to the point that forward P/E ratios were equal to forward P/E ratios for high QR stocks. Historically, low QR stocks have traded at a discount to high QR issues on a forward P/E basis. Corporate earnings growth reached a peak in December 1993, and then began to decline. Additionally, there were extremely low levels of perceived risk among investors as illustrated by the CBOE Volatility Index, which bottomed at a reading of 9.9 in December 1993, just below the recent (July 2005) bottom of 10.6, while the spreads between junk bonds and high-quality corporate issues had narrowed significantly.
The 2000 to 2002 cycle anticipated a November 2000 peak in short-term interest rates (at 6.2%). Forward P/E ratios for low QR stocks had moved well above those of high QR stocks for the first time in over 20 years. The spread between junk bonds and 10-year U.S. Treasury bonds had reached a historical low. Corporate earnings growth peaked in March 2000. This cycle coincided with the worst bear market in over 70 years.
