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The phrase "flight to quality" is familiar in many contexts. In times of crises, many investors favor U.S. Treasuries, even though other kinds of fixed income might offer prospects for much greater return. When equity investors are nervous and when they aren't hiding under their beds (as many seem to be doing now), many run into shares of companies perceived to be safer. Many associate safety with large size and recognizable names. A better way to approach this is to emphasize quality-oriented fundamentals like strong finances, good returns on capital, and so forth.

Staying power

On a normal day-to-day basis, we all recognize the prominence of growth as an investment consideration. We don't usually care about how solid or sustainable that growth may be. After all, if the strong guidance issued Company A is a flash in the pan, we can always switch to any one of countless other names after taking a quick profit in A's shares. But when recession becomes the dominant investment theme, we need to switch gears. Now, the quality of the growth we see (whether manifested as earnings or a lesser degree of shrinkage) becomes important. Today's flash in the pan could be tomorrow's penny stock.

A laundry list

Factors that can be used to measure company quality are all pretty familiar and can be found in the standard how-to books and in the Graham-Dodd type classics. What's noteworthy about recessions is the willingness of more investors to give them higher priority than is the case when times are good.

There are, of course, variations. Below is a list of factors I used in a multi-factor ranking system I developed here to identify "quality" firms. The four broad categories, Returns, Margins, Efficiency and Finances are each weighted 25 percent. All the factors within each category are weighted equally.

  1. RETURNS
    • Trailing 12 Month (TTM) Return on Equity
    • 5-year Return on Equity
    • TTM Return on Investment
    • 5-year Return on Investment
    • TTM Leveraged Return (ROE divided by ROI)
    • 5-year Leveraged Return (ROE divided by ROI)
  1. MARGINS
    • Trailing 12 Month (TTM) Operating Margin
    • 5-year Operating Margin
    • TTM Pretax Margin
    • 5-year Pretax Margin
  1. EFFICIENCY
    • Trailing 12 Month (TTM) Asset Turnover
    • Trailing 12 Month (TTM) Inventory Turnover
    • Trailing 12 Month (TTM) Receivables Turnover
  1. FINANCES
    • Current Ratio
    • Quick Ratio
    • Trailing 12 Month Interest Coverage
    • Debt-to-Capital Ratio

Most of these items ought to be readily recognizable. But a few additional observations are warranted for the Returns category.

Return on Equity is the most widely used metric to measure overall company profitability. But it's important to understand what it's not telling us: the profitability of the business as opposed to the company. They aren't the same thing.

In the context of these returns, a company consists of a business plus a strategy for financing it. Imagine Businesses A and B, two identical outfits with identical factories, identical operating costs, identical revenue streams and identical operating profits. Business A has no debt. Business B, on the other hand, is financed with 10 percent equity and 90 percent debt. Return on Investment will be identical for both: this metric is agnostic as to weather the invested capital comes from the owner or from creditors. But Business B will have a much higher Return on Equity. That metric looks only at the capital put up by the owner.

In recessions, this distinction becomes especially important. High returns on equity could signify high risk if those numbers result from aggressiveness borrowing rather than operational proficiency. That may be even more so in this particular downcycle, where financial crisis is at the epicenter.

This doesn't mean all debt is all bad. I'm not going to ignore Return on Equity, which gives debt-possessing companies credit for their ability to make profitable use of those funds. But when it comes to avant-garde creative expression, I'm happy to see it in art, music, cinema, or literature, but not finance. So I temper consideration of Return on Equity with equal attention to Return on Investment, which shows profitable the business would be if there was no debt. The factors I refer to above as Leveraged Return show the extent to which strong Return on Equity comes from financial strategy as opposed to business performance.

Back-testing the strategy

I backtested a strategy of using stocks from the defensive business list I recently presented (drawn from the consumer, healthcare and utility areas) and choosing from that sub-universe the 20 stocks having the highest scores based on this quality-oriented ranking system. I used the Portfolio123.com advanced back-tester to create hypothetical portfolios at the start of each week between 3/31/01 and 9/13/08. All were then "held" for only four weeks. In other words, portfolio 1 ran from day 1 through day 28; portfolio 2 ran from day 8 through day 35, portfolio 3 ran from day 15 through day 42, and so forth. The results reflect the average performance of the 390 four-week portfolios thusly created.

The results are shown in Table 1.

Computations are for stocks with market capitalizations of at least $250 million Defensive Groups includes filters described in a previous blog.

The top two rows confirm something we recall from day-to-day experience. When the overall market is strong, these quality metrics are not highly cherished by investors. But in down markets, highly-ranked stocks outperform, albeit modestly.

The last two rows, which show what happens when we apply the quality-oriented ranking system to a limited universe consisting solely of defensive stocks confirms the efficacy of paying more attention to these factors when market conditions are bearish. We see lackluster relative performance in up months. But that's not something over which I'd lose sleep. The whole point of a recession-oriented strategy is to cushion the downside. If we can more or less keep pace with the S&P 500 when prices rise, that's fine.

The bottom row is the one that shows this strategy works. The third row tells us it doesn't improve on the downside performance we could get simply by owning the defensive list in its entirety. But realistically, we can't do that since the defensive list numbers about 500 issues. The significance of the quality strategy is to give us a way to make the defensive list investable, by confining it to just 20 stocks. The current list can be seen in Table 2.

A change of pace

Let's back-track a bit and examine a pictorial representation of the performance of this ranking system. Figure 1 shows the annualized performance logged by different groupings over the past two years.

The red bar at the far left represents the S&P 500. The dark green bar on the far right represents the defensive stocks ranking in the top 10 percent; The second-from-the-right dark blue bar represents the next 10 percent, and so forth.

Consistent with what Table 1 suggested for the larger back-test, the better-ranked stocks significantly outperformed the weak market.

Interestingly, so too did most other groups. The main virtue of this system, as it turns out, was to isolate and help us avoid the weakest stocks, rather than point us toward the best. Table 3, shows the results of a backtest of a mid-rank version of the strategy. There, I screened for stocks that ranked between 35 and 65 (on a scale with 100 being best) and pick the top 20 from this collection.

Computations are for stocks with market capitalizations of at least $250 million Defensive Groups includes filters described in a previous blog.

For all practical purposes, the result here is the same as it was when we chose the top-ranked stocks. The names change, as we see in Table 4. But the result is the same.

Putting it together

The short answer for those who are interested in a quality-oriented recessionary equity strategy is to pick either approach, whichever one produces stocks that strike one as most appealing. Another consideration may be size. Market capitalization is not a screening-ranking factor per se. But both lists are sorted, from high to low, based on market cap and when times are tough, many believe that all else being equal, bigger is better. In that case, one could just as easily take the top 10 stocks from each list.

Beyond that, there is good reason to give more substantive consideration to the idea of aiming at middle-rated stocks, as opposed to drawing from the top.

Often, scores at the very top and the very bottom of a ranking reflect extreme developments which can be hard to sustain over time. The statistically notion of mean reversion (a tendency of extremes to eventually revert in the direction of balance) is well established. Those who use technical analysis pursue this through the category of indicators known as "oscillators."

With the quality style, there appears to be no difference between the top and middle. But starting with the next article in this recessionary investing series, we'll see the middle range gaining in strategic significance.

The material herein, while not guaranteed, is based upon information believed to be reliable and accurate. Neither Prism Financial, Inc., owner of Portfolio123.com, nor Marc H. Gerstein, an independent contractor working with Prism (a) guarantee the accuracy, completeness or timeliness of, or otherwise endorse, the information, views, opinions, or recommendations expressed herein; (b) give investment advice; or (c) advocate the sale or purchase of any security or investment. The material herein is not to be deemed an offer or solicitation on our part with respect to the sale or purchase of any securities. Our writers, contributors, editors and employees may at times have positions in the securities mentioned and may make purchases or sales of these securities while this report is in circulation.

Source: Recessionary Equity Strategies: Flight to Quality