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Expert's Podium

Pass on junk and stock up on quality Add to ...

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.

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If you focus on quality firms with strong balance sheets and solid fundamentals, however, you give yourself a good chance of reaping sustained gains over the long haul. That's what the market gurus I've studied - such as Warren Buffett, Benjamin Graham, and Peter Lynch - knew, and it's why I created my Guru Strategy computer models.

My models, each of which is based on the published approach of a different investing great, are designed to pick the most financially sound, fundamentally solid stocks in the market.

Given all of this, I thought it would be a good time to look at some of the highest-quality stocks that my models are keying in on right now. Of course, "high-quality" is a term without a firm definition; for my analysis, I combined a few quality-based criteria from my various models, looking for Guru Strategy-approved stocks that have: increased earnings per share in at least nine of the past 10 years (criterion based on my Buffett-inspired model); current ratios (current assets/current liabilities) of 2.0 or greater (taken from my Graham-based model); debt/equity ratios lower than their industry average (from my Martin Zweig-based approach); and more net current assets than long-term debt (from the Graham method).

I also required a market capitalization of $1-billion (U.S.) or greater, to make sure the company is of decent size.

Very few stocks meet all of those rigid criteria and get approval from one or more of my models. Here are an elite few that do make the grade:

Becton Dickinson and Co.

Yesterday's close: $78.41 U.S., up 50 cents

This New Jersey-based medical equipment firm gets approval from my Lynch- and Buffett-based strategies. My Buffett-based model started targeting the stock in late 2008, not long before Buffett's Berkshire Hathaway picked up BDX shares.

It has a $19-billion market cap, raised its EPS in each year of the past decade, a debt/equity ratio (36.8 per cent) lower than its industry average (41.0 per cent), a current ratio of 2.62 and has about twice as much net current assets as long-term debt.

Infosys Technologies

Yesterday's close: $54.83 U.S., up 29 cents

Based in India, this $31.7-billion market cap IT giant gets strong interest from my Buffett-based approach.

While Mr. Buffett doesn't usually invest in tech firms, Infosys provides what today are essential business services, and has the kind of track record my Buffett-based model likes - it has raised EPS in each year of the past decade. In addition, it has a current ratio of 5.83, and no long-term debt.

Aeropostale Inc.

Yesterday's close: $33.56 U.S., unchanged

You might not think of teen clothing retailers as a good place to find "high-quality" stocks, but this $2.3-billion market cap, New York-based firm has increased EPS in each year of the past decade - through two recessions - and has no long-term debt and a 2.06 current ratio.

It's the only stock in the market that currently gets approval from four of my models - my Lynch-, Buffett-, O'Shaughnessy- and Joel Greenblatt-based approaches.

 

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