Relative Outperformance: Low Quality Stocks

Yesterday, I briefly made mention of the relative outperformance of dreck. Let’s delve deeper into that this morning.

This year, stocks of companies with the strongest balance sheets have markedly lagged shares of firms with the weakest financials. In fact, the YTD performance numbers have not even been close.

According to Richard Moroney, editor of Dow Theory Forecasts, the worst decile of stocks as measured by "debt levels, interest coverage, and profit margins" have gained ~13%. Compare this with a less than 5% gain for the top ten percent of stocks (by those criteria).

Its not just the worst 10% of stocks ranked by debt, interest, and profits that are outperforming: Mark Hulbert notes a similar pattern exists when stocks are ranked according to "three- and five-year growth rates, along with return on equity, assets and investment." The 10% of stocks scoring the worst on these dimensions have gained nearly 11% so far this year, in contrast to a mere 1.4% for the 10% with the best scores on these dimensions.

Hmmmm, quite interesting . . . and there’s more:

Standard and Poor’s reported Monday that "stocks with average to low S&P Quality Rankings (B+, B, B-, and C) have continued to outperform those with high Quality Rankings in recent months." S&P’s Quality Rankings are based on dividends and "quality of earnings" measures.

Hulbert makes a very significant observation about this historical pattern of  low-quality issues outperforming high-quality issues: It occurs at two points in the market cycle: at the very beginning of a bull market — and at its tail end.

So that raises the very obvious question: Where are we int he present cycle? Is this the beginning, or (with apologies to Third Degree) is this the end?

You know my views.

Its not impossible for this to be the start of a new  multi-decade Bull market. However, for this to happen would require a historically unprecedented break from numerous other precedential factors:  the 4 year cycle, a P/E mean reversion, typical lengths of Bull and Bear Markets, P/E multiple expansion / contraction cycle, etc. It also means that all of the structural imbalances we have observed are utterly meaningless, and that irresponsible spending by both governments and consumers have no negative impact on the overall economy.

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Incidentally, if this is the beginning of anew Bull run, I don’t mind being wrong — just so long as I can reposition before hand.

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UPDATE March 22, 2006  1:55pm

In addition to the information above, consider these two charts below:

click either for larger graph

Contrahour points out that Nasdaq volume has been outpacing the NYSE volume:

Nasdaqnyse_volume

and Sentiment Trader notes the big spike up in bulletin board stock volume:

Otc_bb_volume_032006

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Source:
Is this the end, or just the beginning?
Mark Hulbert
MarketWatch, 12:01 AM ET Mar 21, 2006
http://tinyurl.com/po3rl

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What's been said:

Discussions found on the web:
  1. Chad K commented on Mar 22

    What is the fear of companies with excellent bottom lines in a time of crisis? That they’re fabricating their amounts? That it’s too good to be true?

    I’d like to know, how well do those stocks typically do when you get outside the tail-end and into the bear market?

  2. anon commented on Mar 22

    since you are so straightforward and offer good critical judgement, i am curious to see who are your favorite contributors to Real Money. I have been a subscriber for a long time, and have noticed more and more contributors every month. Most of it seems geared to day trading or swing trading at best (not advised for the public) or very poor commnetary by some who are consistently wrong or should be used as contrary indicators. Any thoughts. Guy Lerner seems very off base to me, amongst others

  3. Bynocerus commented on Mar 22

    I don’t think Guy Lerner has been off base at all over the last year. He became heavily long the Naz in May 05, and he’s been range trading the market pretty successfully over the last four months. Most importantly, he is very precise about what he’s doing – a trait few other RM contributors possess.

    I know the question is for Barry, but I really think Helene Meisler is one of the best contributors anywhere, RM included. On the flip side, Dick Arms has consistently been a contrary indicator on the broad markets for a LONG time. When the markets were rallying from October to January, nearly every post was on how we shouldn’ t trust the rally. However, since the start of the year, nearly every post, his most recent being the exception, has been how you’re going to miss out on the rally if you’re not long. Exactly which rally he’s talking about I don’t know.

  4. rob commented on Mar 22

    I would think the companies in the high quality camp would also be the companies with the highest existing ownership by investors, leaving less upside then lower quality stocks which benefit from the discovery factor so neccesary for price appreciation.

  5. B commented on Mar 22

    Get ready for the death march. The oil implosion is coming. It’s different this time? DOH!

    Take from McKinsey. Uhhh, might I add their management consultant team advises global leaders of government and industry with few equals. ie, They aren’t the latest incarnation of Henry Blodget

    Since 1998, the industry has enjoyed its longest boom in 40 years . Cash is gushing into international oil companies after the recent jump in the price of oil and gas. According to our estimates, the five largest corporations generated more than $120 billion in cash flow before capital expenditure in 2005—equivalent to about twice their capital expenditure over each of the past few years and more than one and a half times the annual cash flow recorded during the industry’s last boom, from 1979 to 1981. Suppliers are also benefiting: oil field service companies are expected to report increases of more than 50 percent in full-year 2005 profits over the figures for 2004.
    What should companies do with the extra cash? Although executives might be expected to relish such a problem, the decisions they make will have ramifications far beyond the oil industry. On the one hand, companies face pressure to invest more in exploration, production, and refining (where margins have also risen): consumers and governments are angry about high prices, the industry’s large profits, and the channeling of those profits into share buybacks and dividends rather than into investments that might bring down prices. On the other hand, with the industry outperforming the S&P 500 by almost 30 percent since 2003, the capital markets seem to be rewarding companies for the share buybacks and dividends—amounting in total to almost $120 billion—that have been announced during this period
    The conundrum is this: has the industry entered an era of permanently higher oil and gas prices and refining margins or is it merely experiencing another market bubble? If executives believe the former hypothesis, they will focus their companies’ excess cash on long-term investments, though at the risk of precipitating the kind of price collapse that would destroy the value of those investments. If they believe the latter, they will return the cash to shareholders and risk missing opportunities to create value over the long term if prices remain high.
    We believe that such crucial decisions would be better informed if the industry were to reflect upon its history—in particular, its inability to return its cost of capital over four decades of boom and bust. Coupled with an understanding of the economics of new capacity and of alternative fuel technologies, the evidence suggests that dangers await companies that place too large a bet on a fundamental structural change by investing in projects that will be profitable only if the market has indeed altered for good. They would do better to exercise discipline over capital spending and to invest in opportunities to build sources of competitive advantage that they can sustain regardless of whether prices shift structurally or revert to levels closer to the long-term averages.
    A familiar road
    The history of the oil industry is long on boom-and-bust cycles in crude prices and refining margins and short on examples of capital discipline. In the 25 years to 1998, the industry’s total return to shareholders (TRS) was below that of the S&P 500 because the industry failed to return its cost of capital over the cycle. During booms, oil companies would behave as if the world had changed permanently, investing in projects that could make a profit only if prices stayed high. The exceptions were the larger, globally integrated companies, such as BP, ExxonMobil, and Royal Dutch/Shell, which delivered TRS in line with the overall market. These companies did show capital discipline: they made strategic investments in assets and technologies, including very large oil fields and deep-water drilling, that demanded specialist capabilities and large amounts of capital, as well as investments in refining portfolios that use better technologies and are located in economically attractive places. In this way, they generated returns roughly in line with the cost of capital over the cycle.

  6. GRL commented on Mar 22

    One somewhat related question I have is this:

    Given that we are in a rising-interest-rate environment, why are REITs doing so well?

    They *should* be tanking. Yet, the one REIT I own (WRE, a “blue chip”) recently hit, and has been hovering around, a new 52 week and all time high. Looking at others, I can see that mine is not a unique experience.

    What gives?

  7. B commented on Mar 22

    You know that reit was 40 cents a share in 1975? lol. You must be RICH! Your reit is not trading at a premium to the market and it is not exposed to single family homes where any bubblicious behavior has been more severe. As long as its dividend yield remains highly correlated to the ten year, you are likely riding a winner. (Many reits are trading at a premium to the ten year and those are the ones to be very afraid of IMO.) It will suffer in a downturn but the thirty year chart is a thing of beauty.

    Short term it has just bumped up against a thirty year resistance line. The last time it did that was July of 05 and it wavered for a few months before it fell back to $28. Thus, I would expect weakness to set in here within a short period of time. But, unless you are a trader……That is no reason to sell IMO. I’d keep my eye on ten year rates, “$TNX” on Yahoo Finance. Unless your dividend yield on this gets disproporionately out of whack with ten year rates, your downside should be limited. I think ten year rates will rocket eventually but then again, future predictions are for jokers.

    The last time we had a real estate bubblet and a slow down, 1990ish, the stock dropped about 25%.

  8. nate commented on Mar 22

    Bears on future and others: consider column by Martin Wolf in the March 22 Financial Times.

  9. bill commented on Mar 22

    I have just begun reading ‘How We Know What Isn’t So’. This book points out that the extremes usually tend back toward the average when chance plays a role in their outcome. In other words, some of these stocks are not as bad or as good as the numbers indicate. So, if you take the worst, and wait for them to bottom out from public perception of the numbers, many should bounce back (provided there is not a predictable downward trend for a given stock).

  10. GRL commented on Mar 22

    B:

    I first bought WRE back in the early ’80’s, and have been dollar cost averaging small sums into it off and on ever since, so no, I’m not planning to sell. The only issue is whether I should temporarily stop buying my monthly dollar amount of shares until the price goes back down.

    I sold my shares of AMGN that I bought right after the crash of ’87 in June of ’88 (stupid move) so I could keeps WRE and still afford to put a down payment on my house. But the really stupid move was not backing up the truck in 2000 when the stock was trading in the low 20’s (if memory serves) with a 7% yield (that yield, I do remember).

    Another concern I have is that this traditionally has been a mom and pop, widows and orphans stock, whose management had always been extremely conservative, but a few years back, there was a management change (the old CEO, I think, retired), and the new management has gotten into construction (which the old management didn’t do) and trying to attract wall street investors (institutions, mutual funds, pensions, etc.). I could be wrong, but I also think they have increased the leverage somewhat. Since they are still pretty conservative (if somewhat less than before), at this point, I do not yet see a reason to sell, but it does concern me.

    But what most concerns me is that the price *has* gotten out of whack. Traditionally, this stock has always been overvalued in relation to the other REITs, but it has always yielded more than the 10 year note and 30 year bond, which makes sense from an individual perspective, if only because the T-note and bond are not subject to state and local taxes, while REIT dividends are fully taxable as ordinary income.

    Now however, with the 10 yr. yielding 4.7 and the 30 yr. yielding 4.74 (as of 10:45 am today), WRE only yields only 4.6 (historically, WRE’s yield has been in the 5-5.5% range), which, to me, says it is way overpriced, even in comparison to its traditionally high valuation.

    Intuitively, other REITs seem to be the same way, though I haven’t done the calcs on them.

    One thought that crosses my mind is that institutional buying may be driving up the price . . .

  11. Bynocerus commented on Mar 22

    Alright already. Which one of you pressed the “unpimp ze rally” button. This is twice in two days. Honestly, someone needs to be more careful around the equipment.

  12. Michael C. commented on Mar 22

    I share every single one of your opinions.

    Guy Lerner, he is an intermediate term trend trader with tight stops. As a result, he catches big trends that give him the big gains while in the mean time the tight stops eat into those gains when they are triggered in a whip saw market. In the end, his systems have very good returns. Moreover, I have never seen the market take off when he is on the other side.

    HM is excellent.

    I can’t believe you said that about Dick Arms. I have been thinking that for a very long time and thought no one ever noticed how wrong he is so much of the time. Makes me question how he uses his own indicator.

    Surprised you didn’t mention Bob Marcin. I have never seen any commentator disparage so many others as much as he does and, as a result, infer that he is high up on his own pedastal while everyone else is lowly and somehow not seeing things as they should through his omniscient eyes. He is sickening.

    And, of course, Barry. Excellent.

    >>> don’t think Guy Lerner has been off base at all over the last year. He became heavily long the Naz in May 05, and he’s been range trading the market pretty successfully over the last four months. Most importantly, he is very precise about what he’s doing – a trait few other RM contributors possess.

    I know the question is for Barry, but I really think Helene Meisler is one of the best contributors anywhere, RM included. On the flip side, Dick Arms has consistently been a contrary indicator on the broad markets for a LONG time. When the markets were rallying from October to January, nearly every post was on how we shouldn’ t trust the rally. However, since the start of the year, nearly every post, his most recent being the exception, has been how you’re going to miss out on the rally if you’re not long. Exactly which rally he’s talking about I don’t know.<

  13. Mark commented on Mar 22

    Bynocerus-

    It’s just another sign of aging. The morning oatmeal and Postum wears off and the Metamucil kicks in.

  14. B commented on Mar 22

    My God,
    I need to get long. The rally is leaving me behind! Today’s winners were copper stocks and airlines! New highs expanded to 80 and up volume was half that of down volume on the NAS. A new bull market has begun!

    In a world where we haven’t had a correction of significance in three years and the economy is suspect at best, it is time to pay homage to all who are leveraged to the hilt in the $350 trillion derivatives market. A view of centrally planned China’s upcoming crisis? Riots in the street? Political unrest?

    This is an ominous reminder of what happens when the world goes too long without a reset in behavior. Btw, Stan Jonas of Fimat is on this video. He’s likely a top five smartest SOB on Wall Street and I’ve tried time and again to dig up some access to his commentary or research. Anyone have access or know if he publishes anything?

    http://www.michaelcovel.com/archives/000749.html

  15. Larry Nusbaum, Scottsdale commented on Mar 22

    “Incidentally, if this is the beginning of anew Bull run, I don’t mind being wrong — just so long as I can reposition before hand.”

    HOLD ON! BRB WITH ALL 5 OF NEXT WEEKS’ WALL ST. JOURNALS. – { The standard payment is a soul. }

  16. angryinch commented on Mar 22

    The outperformance of crap stocks already occurred at the beginning of this bull run in ’03. The fact that it’s occuring again means we’re probably getting ready for a breakdown again.

    BTW, the pattern of this run off the ’02 lows looks a lot like 90-94. The rally off the Oct 90 lows extended to Mar 94—41 months. The rally off the Oct 02 lows is now 41 months exactly.

    Even the pct gains are roughly similar: SPX 64%/71%, Dow 71%/57%, RUT 116%/130%.

    The market broke down hard from Mar 23-Apr 1 1994, losing about 10% in 8 days. That was the nominal low for the year on the SPX, though the RUT and Nasdaq made lower lows in late June and mid-Dec. It was a particularly bad year from a pct standpoint, but stocks were unable to gain any traction at all under late Dec…which led to a huge gain in 1995.

    The March ’94 breakdown coincided with a bond rout as 10yr yields jumped 1% in 8 days. Bond yields topped in Nov ’94 (at 8%+) and haven’t revisited those levels since.

  17. jb commented on Mar 22

    Man, am I glad to see this. I’ve only been trading for about 6 months, and I’ve noticed it. I was starting to think its always like this. :-) …BTW, I bought a year subscription to RM 4 months ago, mostly to read Gary B Smith. Nice timing, huh?

  18. JO commented on Mar 23

    “it is time to pay homage to all who are leveraged to the hilt in the $350 trillion derivatives market.”

    Correct me if I’m wrong, but didn’t we just pass the $280 trillion mark sometime in September or October of last year? Beyond comprehension…

    Out of curiosity, since many of the readers here seem to have very detailed knowledge of the markets and trading, has anyone ever met the physics geeks and maths wizards who create these derivatives contracts on a regular basis? Do they ever wonder about the wider implications of their creations, or are they so fixated on the arcane formulas involved that further thought is out of the question?

    Reading about Warren Buffet’s experiences with General Re’s unwinding of their own derivatives contracts (what, 15 years for 10,000 odd contracts, and he still isn’t done?), something seems very, very wrong with this ephemeral world that hovers above the world’s markets. I’m not informed or knowledgeable enough about it to criticise it with any sort of depth, but if WB maligns it with such vehemence, there’s got to be something deeply wrong…

    Any further comments or explanations would be gratefully acknowledged.

    Cheers

  19. Guy Lerner commented on Mar 25

    Hi! I happened to notice comments regarding myself and I am flattered that folks are reading my work from RM – regardless if you agree with me or not –that’s ok!!!

    For the most part, I would like to think of my work suited for the investor trying to capture trends that last greater than 4 weeks in time. For example, I was bullish on the NASDAQ/market in mid-October, 2005 and became bearish Feb. 3, 2006. Within that context, I execute a whole host of bullish strategies.

    As I run my own website with subscribers, I do not share all my strategies or ideas on RM. For example, I was long the IWM from early Nov. 2005 until mid Feb 2006.

    As a writer for RM, I try to distinguish my work by staying to the intermediate term; I feel that this is the best way to make money—not day trading or even swing trading (too hard to execute). I feel it is hard to have a “voice” on RM because it does seem very suited to the quick fingered day trader type. This isn’t my gig.

    I try very hard to be clear and precise in my writings. I think a lot of commentators waffle and it is hard to decipher what they are really doing.

    As always, I welcome constructive criticism and dialogue as I know better than to think that I have a corner on the market.

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