As Economy Hits Headwinds, Many Investors Seek Higher-Quality Stocks

By Norman F. Klopp, Jr., CFA, Partner

It’s now evident the economy is facing various risks:

The rate of economic growth in the U.S. appears to be slowing; energy prices remain high; the geopolitical outlook is unclear, at best; interest rates are rising; and inflation concerns are increasing.

S&P Data

With that as background, the table below shows some of the disparities that exist between the highest-quality and lowest-quality stocks in the Standard & Poor’s 500 Index, a broad market-weighted average of U.S.-based large-cap, blue-chip companies.

The table compares various aggregate average characteristics of stocks rated A+ or A to those rated B- or C.

All quality ratings were made by Standard and Poor’s, a division of The McGraw-Hill Companies, Inc.

Several significant facts emerge from this chart, and they are dramatic! When compared to the lowest-quality stocks, the highest-quality stocks:

• Are 60% more profitable when measured by return on equity;
• Have grown earnings at a double-digit rate;
• Have experienced dividend growth ten times faster;
• Have a current yield more than double;
• Are significantly less volatile (risky) when measured by their beta — a coefficient which measures the volatility of a stock’s returns relative to the market (S&P 500 Index).

In short, profitability, earnings growth, dividend growth, yield and lower risk are all available at a 26% discount, when measured by price-to-earning multiples.

Pertinent questions

And so, as economic risk increases, the debate is accelerating:

– “Will the valuation gap between high-quality stocks and low-quality stocks begin to close?”

– “Will investors begin to lower their investment risk, especially if they can do it at a significant valuation discount?”

We believe the answer to both questions is an emphatic yes.

There will be a flight to quality. In fact, it may have already started.

Opportunity for our clients

Finally, I want to remind our clients that the stocks in Midwest Investment Management’s proprietary Large-Cap Core Value Portfolio represent high-quality companies that add value to their respective stock by growing earnings, cash flow, and dividends.

They are the types of stocks that can offer our clients the greatest opportunity for long-term growth of capital.

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Norm Klopp has an enviable long-term record for identifying quality stocks for clients who want a portfolio positioned for long-term growth. If you are not currently a Midwest Investment Management Client, consider putting Norm’s qualitative stock-picking experience to work for your portfolio. To get started, contact Norm at (216) 830-1135 or nfk@mimllc.com