By Patrick Morris
Some of the best performing portfolios in 2009 happened to hold some of the worst stocks. A high school economics class doing textbook analysis of the companies that benefited most from last year's rally would conclude that the markets can actually be pretty forgiving.
Why was this the case? Debt. As many hedge funds have learned from years of kneeling at the feet of Alan Greenspan, when the federal government releases liquidity into the markets, it's like giving free gas to powerboats that have run dry. The market's version of sailboats may have been doing fine under their own power, but which class of vessel would you bet on to win an earnings race?
Much the same has happened in the markets, with the most debt-fueled businesses getting a government-sponsored reprieve from their fiscal obligations, while the stocks of companies with cleaner balance sheets have languished. Any good trader had to ignore fundamental analysis last year to beat the indices—and lots did. But now there's widespread fretting about when the laws of gravity will return.
Without the benefit of a crystal ball or trustworthy gut instinct, we look at historical data in the context of recent returns to determine where we are in the economic cycle. We identify companies as high quality if there is a very narrow gap between their earnings and their cash flow, and we identify companies as low quality if there is a very wide gap.
We have found that stocks we have deemed high quality also tend to have stable and persistent earnings, high returns on equity, stable and wide profit margins and low debt levels. A portfolio of high-quality stocks often contains consumer staples and regulated utilities. These stocks show far less propensity for accounting manipulation and/or fraud, protecting the portfolio from headline risk.
It's easy to ignore these factors in a boom year, but reality has a way of showing up when it's least welcome. Enron and WorldCom were market darlings with great earnings—until they weren't. Standard & Poor's ran a risk-return analysis for its annual quality rankings from 1986 to 2004. Not surprisingly, both equal-weighted and market-weighted, the high-quality stocks outperformed their low-quality counterparts. Over the period from December 1999 to February 2009, stocks deemed high quality, according to S&P, outperformed those stocks deemed low quality 55% of the time, with an average spread of 4.2% per month.
The past year witnessed an unprecedented reversal to this otherwise intuitive trend. From February 2009 to March 2010, high-quality stocks outperformed low-quality stocks only 30% of the time, and the average spread fell to a disappointing 3.1% per month. The average spread of the 70% of low-quality stocks that outperformed rose to 6.7% per month.
I think the winds are about to change, because the magnitude and the frequency of this reversal is unparalleled to any other reversal of its kind over the past 10 years, even during the 2003 rebound when the Federal Reserve pushed the inflation-adjusted federal funds rate into negative territory. The only other two times that we saw anything close to this extreme reversal to low-quality stock outperformance, with spreads in the bottom 10%, was in 2000 during the peak of the Nasdaq and in July 2008, just months prior to the collapse of Lehman Brothers.
The market rally of the past year was driven by speculation in these low-quality stocks, given that their highly leveraged balance sheets benefited from low interest rates and an improving economy. The most elusive but most commonly used instrument is timing. In hindsight, we all could see previous collapses coming, but did we act on them or could we have acted on them in a timely fashion? It is inevitable that the good stocks will once again overtake the bad stocks. How will you know when to get out?
So as the speculative side of the market declines, the undervalued large cap names can catch the market and give some buoyancy to the headline index returns. Market regimes will change, and ultimately earnings growth, earnings quality, margins and low debt levels will matter. I'm not taking any chances that I can outwit reality. The time to rebalance into quality is now. Don't fly too high on those crappy borrowed wings.
Patrick Morris is the chief executive officer of Hagin Investment Management, a quantitative hedge fund in New York.