NEW YORK (Reuters) - Last year’s breakneck rally in U.S. equities was fuelled by poor quality shares, but trade in 2010 is likely to be driven by select, high quality stocks.
The market will not be able to rely on the seduction of cheap prices this year. Selectivity is the buzzword now, and as the search for “quality” drives stock picks, many analysts say well capitalized, defensive companies will be a favored hunting ground.
“Investors have turned their focus toward consistent revenue growers that are churning out reliable earnings growth,” said Joe Keating, chief investment officer, RBC Bank Investment Management in Birmingham, Alabama.
This process has already begun. Both the S&P MidCap 400 index .MID and S&P SmallCap 600 index .SML surged more than 80 percent from March lows, while the broad S&P 500 was up more than 60 percent, but the large-cap index outpaced their smaller brethren in the fourth quarter of 2009.
High quality names are traditionally thought of as shares of companies with larger market capitalization, low debt loads and a leadership position in their respective industries.
Even so, the selectivity mantra does not mean the sectors which saw the best performance during 2009’s rally will decline in 2010. That’s because quality can be somewhat of a foggy notion, as companies with steady earnings can continue to lag those with growth potential through bull markets.
In all but one previous bull market, low-priced stocks outperformed those with strong debt ratings, according to Jeff Rubin, market strategist at Birinyi Associates in Westport, Connecticut. “Basically, you want to dance with who brought you to the party,” he said.
The best-performing sectors through bull markets are those associated with expansion -- materials, consumer discretionary stocks, and technology, according to Bespoke.
In 2009 investors piled into beaten-up stocks that had been pounded in 2008. Many of these were shares that did not pay dividends, and many were also favored targets of short-sellers.
But rise they did -- the 50 stocks with the lowest market cap in the S&P 500 at the end of 2008 gained on average 113 percent in 2009, according to Bespoke Investment Group in Harrison, N.Y.
Though cheap stocks provided the fuel for the market’s fiery run-up, the massive rally has not pushed stocks to expensive valuations.
Price-to-earnings ratios fell to bargain basement lows before March’s rebound, trading at around 11 times earnings expectations, according to Alec Young, equity strategist at Standard & Poor’s in New York.
Improved corporate outlooks have stocks at about 15 times forward earnings expectations for 2010, said Young, about in line with historical averages. He expects stock to stay in a range in 2010, trading between 16 and 16.5 times expectations.
“The valuations of some of the larger cap companies look pretty compelling,” said Eric Marshall, director of research at Hodges Capital Management in Dallas, Texas.
Trailing 12-month valuations will look even more attractive when the fourth quarter of 2008 falls out of the calculation, as S&P 500 earnings were negative for that quarter.
The search for value will have investors trying to single out firms with the greatest profit potential after a year where investors were merely happy to hear that the outlook was not worsening.
Companies that have weathered the downturn best are expected by many to continue to show strong earnings growth through international exposure, an increased market share from competitive attrition and increased efficiency.
This favors large caps, but smaller companies in niche markets have more potential to benefit from the disappearance of rivals. In a December note, Citigroup investment strategist Tobias Levkovich named 10 companies with these attributes, among them Goldman Sachs <GS.N,> 3M MMM.N and Procter & Gamble PG.N.
“The higher beta trade has been rewarding, but it is time to buy corporate leaders with strong cash flow and sustainable dividends,” he wrote. “If slow growth is indeed the future trend, quality will matter.”
S&P 500 companies are expected to show earnings growth of just over 37 percent in the first quarter, according to Thomson Reuters research. This is a handsome increase from the 23 percent growth analysts were expecting last April.
While the more conservative investment approach may appeal to those burned by the financial crisis, it doesn’t necessarily spell the most returns. In 2009, S&P 500 companies that pay dividends had a 26.2 percent average gain for the year. Non-payers posted a hefty 65.3 percent gain.
“It may be flip, but any stock that’s going up in our portfolio is high quality to us and to any investor,” said Rubin.
Editing by Andrew Hay
Our Standards: The Thomson Reuters Trust Principles.