High Return Junk Stocks - What's Next (Hulbert in NYT)

December 6, 2009
Strategies
When the Performance Looks a Little Too Good
By MARK HULBERT

SANMINA-SCI, the supplier of electronics services, is loaded with debt and in each of the last eightyears has lost money. Its shares have risen more than 600 percent since the stock market rally began on March 9.

Wal-Mart Stores, the discount retailer, has lots of cash on its balance sheet, has very little debt and has consistently turned a profit. Since March 9, its shares have gained just 14 percent.
The disparate treatment meted out to these two companies by the stock market highlights an unusual and, in some ways, worrisome phenomenon: to an extent not seen in decades, shares of companies with weak balance sheets have been soaring, generally outperforming firms with stronger fundamentals.

In part, this is a consequence of the terrible pummeling given to riskier assets of all kinds during the worst months of the financial crisis. Shares of companies that were deemed to be weakest were hit the hardest. It’s only natural that they would bounce back the most at the first hint that financial disaster had been averted.

But the performance gap between the weak and the strong has rarely been as pronounced as it has been since March’s market lows. The extreme outperformance of the more speculative stocks could make them vulnerable to another market shock.
Ford Equity Research, an independent research firm based in San Diego, rates stocks’ financial quality based on a number of factors, including a company’s size, debt level, earnings history and industry stability. All told, Ford Equity follows more than 4,000 stocks. Those in the bottom fifth of its ratings — including Sanmina-SCI — produced an average stock market return of 152 percent from the beginning of March to the end of November, according to an analysis conducted for The New York Times.

The stocks in the highest quintile for quality — including Wal-Mart — produced an average gain of 66 percent over the same period, or roughly 85 percentage points less. That is the biggest disparity over the first nine months of any bull market since 1970, which is the first year for which Ford Equity has quality ratings.

Historical comparisons to bull markets prior to 1970 must rely on a proxy for financial quality, and perhaps the best available is market capitalization. Not all large-cap companies are financially healthy, of course, and not all small caps are weak. But, historically, as a group, the difference between the large- and small-cap sectors has proved to be roughly correlated with the disparity between high- and low-quality stocks.

Since the March lows, for example, according to Ford Equity, the 20 percent of stocks with smallest market capitalizations have on average outperformed the largest 20 percent by 72 percentage points — only slightly less than the 85-point disparity between the lowest- and highest-quality issues.

By contrast, in the first nine months of all bull markets since 1926, the average outperformance of the small-cap sector was just 21 percentage points, or less than one-third as much as the disparity over the last nine months, according to calculations by The Hulbert Financial Digest.

Only once since 1926 have the first nine months of a bull market produced a gap greater than this year’s. That was in the bull market that began in February 1933, in the middle of the Great Depression, when small caps outperformed large caps by an incredible 196 percentage points.

How can we explain the current extreme performance disparity? The federal government’s stimulus program is the main cause, in the view of Jeremy Grantham, the chief investment strategist at GMO, a money-management firm based in Boston. Mr. Grantham said in an interview that by temporarily reducing the danger of incurring risk, the government had effectively encouraged huge amounts of risk-taking in financial markets. “The sizable disparity of junk over quality should not have come as a big surprise,” he said, “given how massive the government’s stimulus has been.”

As an unintended consequence, Mr. Grantham said, high-quality stocks today are about as cheap as they have ever been relative to shares of firms with weaker finances.

“It’s almost a certain bet that high-quality blue chips will outperform lower-quality stocks over the longer term,” he said.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.