John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds.
With the major U.S. and Canadian indexes between 50 and 80 per cent above their March lows, a rising tide has lifted the vast majority of stock market ships in 2009 - though certain types of stocks have really ridden the wave.
One of those areas: so-called junk stocks - those that have the worst balance sheets and fundamentals. According to some analysis, the lowest-quality stocks (based on factors such as earnings history and debt level) have outperformed the highest-quality issues by a greater than two-to-one margin since March.
It's not surprising, really. In financial crises, junk stocks tend to get hit particularly hard, because companies with weak balance sheets are least likely to survive a depression or major recession. Fears of financial Armageddon drive them down - sometimes to irrationally cheap levels. That's just what happened last fall and winter.
When the crisis passes and fears relent, however, investors snatch up Armageddon-priced stocks that have survived; that's how a troubled, beaten-down stock such as Citigroup can surge more than 200 per cent in a matter of a month or two, as it did earlier in 2009.
If you focus on quality firms with strong balance sheets and solid fundamentals, you give yourself a good chance of reaping sustained gains over the long haul.
A junk rally will only last for so long, however. Eventually, a company has to produce results in order for its stock to keep gaining. And many top strategists are saying that we're now transitioning into a period in which investors will get off the junk train and turn to higher-quality stocks.
Bob Doll, Donald Yacktman, and James O'Shaughnessy are among those who have recently said they see good times ahead for high-quality firms; Jeremy Grantham has even said it is "almost a certain bet that high-quality blue chips will outperform lower-quality stocks over the longer term."
To me, high-quality stocks are always a great place to be. Junk rallies can be powerful but are highly unpredictable, requiring you to anticipate when the fear spiral driving junk stocks down will end, and how long the ensuing bounce-back period will last.
