When to Move From High-Fliers to High Quality Stocks

by: Arnbjorn Ingimundarson, CFA

While it is said that a rising tide lifts all boats, market returns have not been evenly distributed in the sharply rising market of the last two years. Some of those hard hit in the downturn, for instance commodity producers, have come back very strongly. Others, banks being a prime example, have faded after an initial rebound.

These trends are well understood and have reasonable economic explanations. But there are other market divergences which are not as easily explained through rational economics. Here I will highlight two groups of companies, which I have dubbed “High Quality” and “High-Fliers." The former group consists of large capitalization stocks with a long history of strong earnings and that are currently trading at a modest valuation. The latter group consists of stocks which have revenue and earnings that are growing rapidly, but whose stock prices have grown even more rapidly of late and currently have very optimistic expectations baked into their stock price. Following are somewhat arbitrarily chosen samples of 10 stocks from each group:

Click to enlarge charts

As can be seen from the tables, P/E ratios for the former group are between 9 and 14, whereas only one company in the latter group has a P/E ratio under 50. That is not to say that the two groups should be trading at similar P/E ratios -- the High Fliers generally do have better growth prospects. However, they are also riskier and it is more likely that some of them will see a sudden reversal of fortune. While it is hard to generalize, as it is a very diverse group of companies, it is my opinion that it is speculation and momentum chasing, rather than fundamentals, that is carrying them higher at this point.

The difference in performance between those two groups in the stock market from the beginning of 2009 is astounding. The average total return for High Quality (including dividends) in this time period is a mere 12.7%. For the High Fliers, it is 400%. The following graph shows how the High Fliers have performed relatively to High Quality in this period, along with a 200 day moving average in red:

It is remarkable how consistently the High Fliers have outperformed during this period. Typically, such strong trends end with strong reversals. The tricky part is knowing ahead of time when the reversal will occur.

One idea for those interested in shorting shares of High Flier companies and/or buying shares in the High Quality group would be to wait for a clear trend reversal, for instance, when the ratio crosses its 200-day moving average to the downside.

Disclosure: I am long INTC, MSFT, NVS, T.