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One of our readers suggested we write this article after reading previous posts that indicated a market correction is imminent. Please tell us what else you would like to read about: E-mail Investment Editor Sonali Verma at sverma@globeandmail.com

Everybody professes to hate The Vampire Squid, yet considerable respect for Goldman Sachs research remains. So when chief U.S. strategist David Kostin predicts a 10-per- cent correction in the S&P 500, the wise investor starts building a shopping list of potentially lucrative U.S. equity opportunities.

What are the most promising candidates for outsize performance after a downdraft ends? The high-risk way to profit from a significant market correction is to guess at what the economic and market backdrop will look like afterward, try to time the temporary market bottom, and buy the stocks most likely to benefit.

The biggest returns will be generated this way, but for most investors, the odds of getting it right at all three stages are prohibitive.

Investors are far more likely to succeed if they instead emphasize high-quality stocks, even if the theoretical upside is smaller. Buying companies with stable earnings when they're trading at valuation levels below their historical averages is, after all, the strategy that made Warren Buffett one of the greatest investors of all time.

To find quality stocks, we used the the (S&P) Quality Rankings System, which attempts to capture the growth and stability of earnings and a company's dividends record with a single rank, using 10-year trailing data.

The emphasis is not on the fastest-growing companies but the most stable – the stocks representing profit and dividend growth even in the worst economic scenarios. Because earnings growth is safe relative to the rest of the market, high-quality stocks are particularly likely to generate good returns when trading at below-average valuations.

Some potential investment opportunities are highlighted in the table below. I started with the 50 largest members of the S&P High Quality Rank Index by market capitalization and compared current trailing price-earnings levels to each stock's 10-year average. I discarded all stocks trading above their historic average P/E.

The remaining stocks were then assessed by dividend yield, dividend growth and three-year earnings growth.

Not every company on the list is one you should buy. Comcast Corp. is at the top of the list, but its 10-year average P/E is skewed higher by a period in 2004 when it traded at more than 100 times earnings, suggesting the current valuation discount is less than it appears. Similarly, IBM looks cheap, but hasn't been able to generate any growth.

The health-care-related stocks – Medtronic Inc., Baxter Corp. and UnitedHealth Group – are attractively valued and expected to benefit from demographic factors in the decade ahead. The growth of mobile technology should provide a similar boost for Qualcomm Inc.

Johnson Controls Inc. is already benefiting from a resurgent U.S. auto sector.

The stocks in the table are attractively valued now and will likely get even more compelling as investment opportunities in the event of a broad market correction. At the same time, the potential risks are lowered by the high S&P quality ranking because the odds of a profit-growth slowdown are relatively small.

An opportunistic investment strategy featuring lower-risk stocks, attractive valuations, dividend growth and dependable profits is suitable for investors of all risk tolerances. That's because, done correctly, it's one of the best ways to get rich over the long term.


Click here to download the excel table.

 

High quality stocks trading at below average valuations

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