Stocks: Quality Still Counts

Shares of laggard companies outpaced those with strong financials in the latest stock market rally. That's about to change

By Ben Levisohn

The stock market has gained 58% since its bear-market low Mar. 9, but the rally hasn't lifted all equities equally. As is typical in many market bouncebacks, the worst recovered first. Low-quality companies, those with weak or nonexistent profits, mediocre return on equity, and less-than-stellar balance sheets, outpaced their more solidly profitable peers by nearly a 2-to-1 margin, according to research from Baird Private Wealth Management.

Baird found that companies not earning a profit gained 92% from the Mar. 9 lows through the end of August, compared with a 47% rise for companies that had the highest profit margins. Companies with the lowest return on equity outperformed those with the highest by more than 2 to 1, according to Baird.

But the data also show that this kind of low-quality rally is perfectly normal—and usually short-lived. For one thing, the profit-deficient companies suffered bigger price declines during the worst of the stock market tumult. The companies that were hit the hardest rally the most when it becomes clear they're not going away, but as the market normalizes, the rally will end. "Once this initial burst comes through, high quality emerges," says Aaron S. Reynolds, senior portfolio analyst at Baird.

Buffett and Berkshire May Benefit

Quality, however, is in the eye of the beholder. Adviser Steve Shueh of Roundview Capital in Princeton, N.J., is looking for top companies that will benefit as government support of the financial system is scaled back and fiscal stimulus ends—and private investment replaces public dollars. At the top of his list: Berkshire Hathaway (BRKA). Shares of Warren Buffett's holding company are up just 5.9% in 2009, lagging the Standard & Poor's 500-stock index by nearly 10 percentage points. Investors shunned the stock as Buffett loaded up on ConocoPhillips (COP) as oil peaked, his foray into derivatives soured, and Berkshire lost its AAA credit rating.

But Buffett may have the last laugh. Now his preferred-stock investments in General Electric (GE) and Goldman Sachs (GS), which yield 10% annually and can be converted to common stock, look shrewd. Berkshire's insurance business, too, is holding up better than Wall Street had expected. At Geico, for instance, the number of new policies grew by nearly 11%, at a time of industry contraction. Shueh says the company will perform even better as government support is slowly withdrawn from American International Group (AIG) and the insurance market returns to a more normal footing. And Berkshire's shares are trading near 1.4 times book value, at the bottom of its historical range. "Berskshire is a blue chip," says Shueh. "And cheap." (Cheap, of course, in terms of valuation, as the famously high-ticket stock fetches 3,381.00 per "B" share.)

Beaten-down consumer powerhouses may also provide opportunity. Shares of Procter & Gamble (PG), for instance, are down 11% for the year, lagging the S&P 500's 16.5% gain, and its performance has been deserved.

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