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Many "low-quality" stocks experienced double-digit gains in March and on average showed gains driven by increasing optimism and anecdotal evidence for an economic recovery as well as by some better than expected company reports.

For example, we have noted before that a few managers have been betting on a rise in Carnival Corp. (CCL), and they were right -- this stock has moved up 22.7% YTD despite appearing as a quantitative "focus list" short idea over the past few months. Yesterday we mentioned a few others, such as Harley Davidson (HOG), MGM Mirage (MGM) and Toll Brothers (TOL) (see our comment on the potential for "faith-based" upgrades). However, if there is a market correction, these low-quality stocks will outperform on the downside.

We find tracking "high-quality" versus "low-quality" stocks a useful lens through which to view the markets, and as a good way to generate some longer-term research ideas. In addition, we apply several different long/short weighting strategies to approaches to using these stocks in model portfolios. Below is a summary of the most recent month which we released to subscribers prior to the market open on April 1.

Return Summary for the month ended March 31, 2010
Unleveraged longs: 37 stocks, +6.24%
Unleveraged shorts: 53 stocks, +6.92%

Unleveraged focus list, longs: 11 stocks +8.37%
Unleveraged focus list, shorts: 9 stocks +3.02%

Market Neutral Portfolio: -0.70%
120-80 / 80-120 Portfolio: +1.90%
200-0 / 50-150 Portfolio: +12.73%

S&P 500*: +5.88% (+6.03% w/ dividends)

A Word on the Aggressive Long/Short Model Portfolio
If shorting stocks has been a terrible strategy for most of 2009 and 2010, and there are no signs of this dissipating, why do it at all?

In answer to a fund of funds managers question, we used the same stock picking algorithms and weighting signals as the original moderate strategy, but applied different long/short weights at 200/0 or 50/150. This strategy returned 12.73% in March, is up 10.05% YTD and up 604.69% since 12/31/2004. Upon following this advice, he cautioned this could be "a classic case of data snooping." We disagree with that premise, but realize we have more work to do to prove otherwise. This strategy has a 1.33 Sharp Ratio, a -5.8% correlation with the S&P 500 and experiences much heavier and frequent volatility. Its max drawdown was 17%.

click to enlarge

"High-Quality" Stocks in the Long Model Portfolio

There are 41 stocks in the long portfolio this month, as of the close of March 31, 2010. They include ROST, BIG, GCI, AZO, TJX, DLTR, M, FDO, DV, CMG, BBY, LTD, SBUX, THI, TSN, FMX, NTY, KOF, UGP, PGR, SAN, CM, BAP, TRV, BNS, PCL, BMO, GILD, WCRX, OSK, TW, STX, SNDK, FLEX, JBL, V, UFS, LZ, FCX, KGC and AMX.

20 New Stocks

The 20 stocks new to the list include AZO, TJX, FDO, CMG, BBY, LTD, THI, FMX, UGP, PGR, CM, BNS, BMO, WCRX, TW, SNDK, FLEX, UFS, KGC and AMX.

Leaving the Long Portfolio

The 16 stocks leaving the long model portfolio include: ESI, MAT, HAS, SNI, WYN, TGT, NLY, FITB, AMP, NYB, ABC, NVO, LLL, IBM, SMG and BVN.

11 Focus List Stocks

11 of these stocks go on the Focus Portfolio List, which we think have a particularly good chance of outperforming this month: LTD, THI, FMX, UGP, CM, BMO, WCRX, TW, SNDK, FLEX and UFS. In March, long focus portfolio stocks averaged a return of 8.33% versus 5.88% in the S&P 500.

52 "Low-Quality" Stocks in the Short Model Portfolio

There are 52 stocks in the short portfolio this month. HBI, TRI, FO, MGM, HOG, PC, DAI, TM, FMCN, TOL, AVP, BRFS, BG, ACI, NBR, PDE, HK, WFT, EOG, PXP, RRC, SUN, VLO, SU, BJS, NDAQ, BK, STI, DRE, LAZ, JOE, GENZ, OSIP, MDRX, TXT, TRMB, ATVI, ERTS, MLM, MT, NUE, SMS, CHA, NIHD, CHU, FPL, SCG, SO, POM, FE, GXP and EQT.

24 New Stocks

The 24 stocks new to the short portfolio include: HBI, TRI, FO, PC, DAI, TM, FMCN, HK, EOG, PXP, RRC, NDAQ, STI, DRE, OSIP, MDRX, ATVI, MLM, SMS, CHA, NIHD, CHU, GXP and EQT.

Leaving the Short Portfolio

The 22 stocks leaving the short portfolio include : LINTA, IGT, CCL, ANF, WYNN, PHM, ETFC, HBC, AV, REG, PUK, PWR, AGU, RS, GGB, STLD, POT, MOS, X, USM, TAC and SRE.

Six Focus List Stocks

Only six of these stocks go on the Focus Short List, which we think should have a particularly good chance of underperforming the market over the next month. These include FO, DRE, MLM, SMS, NIHD and CHU. In March, short focus portfolio stocks appreciated on average 3.08%, below the 5.88% return for the S&P 500.

A detailed report is available on Scribd.

Disclosure: None

Source: Low-Quality the Way to Go in March; New Ideas for April