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A Quest for Quality

Spanky McFarland once said “You can fool some of the people all of the time, but you can’t fool mom!” My mom used to tell me to “Pay up for quality, because you’ll rarely be disappointed and you’ll probably forget how much you paid.” The same goes for investing. It pays to focus on quality. At S&P Capital IQ, one measure of quality is based on consistency. An S&P “Earnings and Dividend Quality Rank” is a letter grade assigned to a company based on a variety of factors, chief among them is the consistency of earnings and dividend growth over the prior 10 years. As of March 13, there were 445 companies the S&P 500 that had an S&P Quality Rank, with 135 (30%) ranked A-, A or A+, otherwise known as “above average.” Also, there were 174 companies ranked B, B- or C, or “Below Average.” Finally, 136 were ranked B+ or “Average.”

It should come as no surprise that those companies with a higher consistency of increasing earnings and dividends tended to experience lower price volatility over time relative to the broader market. Indeed, those stocks in the S&P 500 with Above Average quality rankings currently have an average beta of 0.9, compared with the average beta of 1.3 for those ranked Below Average and 1.0 for those ranked Average.

Not surprisingly, long-term total returns were also superior for stocks with Above Average quality ranks. From December 31, 1999, through February 27, 2015, the S&P 500 saw a cumulative 91% in total return and recorded an annual standard deviation of 15.4%. The S&P 500 High Quality Rankings Index gained 229%, and experienced less volatility as its standard deviation was 14.7%. The S&P 500 Dividend Aristocrats, however, posted a 342% cumulative total return while enduring an even smaller standard deviation at 14.0%. Finally, in 2008, while the S&P 500 fell 37.0%, including dividends, the S&P 500 Dividend Aristocrats declined 21.6%. Similar magnitudes of outperformance were recorded by the S&P 1500 High Yield Aristocrats and the new S&P MidCap 400 Dividend Aristocrats. Of course, past performance is no guarantee of future results.

So there you have it. As the equity markets pick up the pace of volatility, investors are probably thinking more about price stability through earnings quality. As a result, they are likely considering those companies with higher S&P Capital IQ Quality Rankings, as these stocks sport betas that are substantially below those of lower quality companies. Investing is a journey. Either you can do the driving or you can let someone else can do it.

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