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Stocks are like shoes
Hanging out with people of dubious character could be plenty of fun. They're exciting. And thus filled with surprises! But sooner or later, you'll wind up sleeping in your vehicle with one eyebrow shaved off and your wallet missing.
Much like people,[link widoczny dla zalogowanych], companies could be of excellent or bad character or at least, their earnings can. In the short term,[link widoczny dla zalogowanych],[link widoczny dla zalogowanych], you could have some fine times with the stocks of companies whose earnings are suspect. In the long run, though,[link widoczny dla zalogowanych], you're best hanging out with the stocks of companies that have high-quality earnings.
Stocks of lower-quality companies have been receiving fire since 2003. In the first quarter alone, low-quality stocks beat their high-class peers by 17.3%, says Fernando Garza,[link widoczny dla zalogowanych], senior analyst at ING Investment Management.
There is no telling how long Wall Street's shady stocks will rally. But when you're investing in the future, quality wins, without doubt, Garza says. From January 1990 through January 2006, stocks judged to achieve the best earnings quality gained 453%,[link widoczny dla zalogowanych], vs. 44% for low-quality stocks.
How can you define earnings quality? At least, it means earnings that aren't inflated by accounting shenanigans.
Finding completely clean companies might be impossible,[link widoczny dla zalogowanych], says Robert Olstein, manager from the Olstein Financial Alert fund. When he decided to start a mutual fund, he considered calling it the caliber of Earnings fund, following a stock service he founded within the 1960s.
He decided against it. "If Used to do call it that, people would believe that all of the companies in the portfolio were clean," Olstein says. "Nobody's all clean."
But earnings quality can produce a big difference, because it did with Boston Chicken,[link widoczny dla zalogowanych],[link widoczny dla zalogowanych], a cafe or restaurant which was when a Wall Street darling. The stock went public in 1993 and more than doubled on its first trading day. Olstein was skeptical. "We said that Boston Chicken's stock price was going to a hat size," Olstein says. "It really was a bank lending money to franchises taking a loss."
He was right. Boston Chicken,[link widoczny dla zalogowanych], now Boston Market, filed for bankruptcy court protection in 1998 and was bought by McDonald's in 1999. The stock fell from a high of $38.75 to zero. Fortunately, Olstein says, earnings are better quality now than they've been in a long time thanks in no small part towards the quantity of high-profile arrests for corporate malfeasance.
Picking apart a company's balance sheet is really a complicated,[link widoczny dla zalogowanych], eye-glazing exercise, and that we can't cover it thoroughly here. At the minimum,[link widoczny dla zalogowanych],[link widoczny dla zalogowanych], you ought to be cautious about a company that reports rising earnings despite the fact that sales growth is slowing or flattening, says Rebecca McEnally, a chartered financial analyst using the CFA Institute Centre for Financial Market Integrity in Charlottesville, Va.
There's just one method to make more money by selling fewer of the products,[link widoczny dla zalogowanych], and that is by cutting costs, she says. "It's a tale that does not wash well," McEnally says. "In today's highly competitive environment,[link widoczny dla zalogowanych], most companies have few costs to cut." A far more likely explanation: The organization is fiddling using its cost estimates.
Standard Poor's takes a different approach, and it's the approach that ING's Garza utilized in his study. S ranks companies by their consistency of earnings and dividends,[link widoczny dla zalogowanych], says Massimo Santicchia,[link widoczny dla zalogowanych], director of portfolio management and strategy at S "It's very straightforward," he says. "It looks for growth and stability of growth over a long time."
Companies ranked A+,[link widoczny dla zalogowanych], A or A- by S for earnings quality come with an average price-to-earnings ratio of 15.7. The P-E price divided by earnings measures how cheap a regular is,[link widoczny dla zalogowanych], in accordance with earnings. Lower is cheaper. Normally, you have to pay a higher price,[link widoczny dla zalogowanych], in accordance with earnings, for these Steady Eddies. "These are extremely valuable earnings," Santicchia says. Although not now.
In comparison,[link widoczny dla zalogowanych], companies rated B+, B or B- minus have an average P-E of 18.1. Companies rated B- come with an average P-E of 28,[link widoczny dla zalogowanych], which is nosebleed territory.
"People are paying reasonably limited to take more risk,[link widoczny dla zalogowanych]," Santicchia says. "It's amazing."
One reason: The economy looks good, the ones are in a mood to take a position, ING's Garza says. "That's when you see speculative securities do tremendously much better than safe ones," he says.
But when you purchase unreliable companies at high prices, eventually you find yourself owning unreliable companies at affordable prices. Like mixing vodka shots and dirt biking,[link widoczny dla zalogowanych],[link widoczny dla zalogowanych], it's just not a good idea.
In short: This is an excellent time to stop hanging out with shady characters and start upgrading your portfolio. You could start with the five stocks in the chart. If you're not a stock-picker, you might think about a fund that appears for high-quality stocks selling at affordable prices. Two good bets which have outpaced the S 500 stock index the past decade: American Century Equity Income (ticker: TWEIX) and T. Rowe Price Equity Income (PRFDX).