Investors are snapping up shares of companies with weak earnings, a sign many have shaken off last year’s jitters and are ready to re-embrace riskier stocks in pursuit of outsize gains.
Through the first two months of 2019, shares of companies with low earnings stability over the past 10 years have climbed more than those with steadier profits, according to data compiled by Bank of America Merrill Lynch. Top performers include communications, energy and utility stocks—such as video-streaming service Netflix Inc. (NFLX) and oil-and-gas producer Hess Corp. (HES) — many of which have more than doubled in value since Jan. 1 to push major indexes within striking distance of their records.
Investors’ willingness to plow into riskier stocks that have less stable earnings recovered after the Federal Reserve’s recent pause on raising rates and growing optimism about U.S.-China trade negotiations, analysts said. Many lower-quality stocks were also the most beaten up during the fourth-quarter selloff, making their re-emergence as the stock market’s leader less surprising, several analysts said.
But the rise of low-quality stocks signals investors’ exuberance in a market that teetered on verge of collapse less than three months ago, analysts said. Many of these companies tend to carry heavy debt loads, have unstable earnings—or even losses—and are often among the first to be sold when investors turn bearish.
“With the market starting to give back some of the gains, higher-quality companies are going to come back in vogue,” said Sam Stovall, chief investment strategist at CFRA Research. “You want to be protective of your assets if you have companies with more attractive price to cash flow, more consistent earnings and pays a higher dividend. They’re not the swiftest of boats, but they’re the most buoyant.”
Using the S&P Dow Jones Indices letter-grade system for ranking the quality and stability of about 1,200 companies’ earnings, Bank of America analysts say the shares of weak earners—those with a grade of B or worse—rose 18% through the first two months of the year, compared with 13% for those that generate steadier profits, carrying a B+ or better.
Lower-quality stocks tend to reside in the communications sector, S&P’s revamp of the old telecommunications group that includes a mix of high-growth internet stocks, media companies and telecom firms, said Jill Carey Hall, a Bank of America analyst. They are also found in the utilities, energy and consumer discretionary sectors, among others.
Among the S&P 500’s (.SPX) best performers year-to-date: Netflix. The communications stock, graded as a B, is up 31% since January, while Hess, which carries a B-, has gained 36%. Online marketplace eBay Inc. (EBAY), a tech stock, meanwhile has jumped 28% so far this year.
But some investors are now watching for signs of cracks in the rally. Renewed concerns about whether the U.S. and China can resolve their trade dispute surfaced last week, as did doubts about the health of major economies. That pulled down the S&P 500, which saw its biggest drop of the year last week.
Lower-quality stocks sold off more sharply than stronger earners, pushing an index tracking the 100 lowest-rated stocks in the S&P 500 down over the first week of March by a bigger percentage than a similar benchmark tracking shares of higher-quality companies. That coincided with a flare-up in volatility, with the Cboe Volatility Index (.VWB), which measures expected swings in the S&P 500, rising 18% in the first week of March, its biggest jump since late December.
Volatility could flare further if investors see signs that growth in the U.S. and other parts of the world is slowing faster than expected, if there’s a re-escalation in trade tensions or how the Fed handles further rate increases, money managers said. The U.K.’s potential split from the European Union also has the potential to stir the market.
That could be a catalyst for gains from high-quality-earning companies that have a better shot at withstanding wild swings in the market, analysts added.
High-quality havens include consumer staples—which tend to generate steadier profits since people need essential household goods regardless of economic conditions—as well as industrial stocks, Ms. Carey Hall said. Warehouse club retailer Costco Wholesale Corp. (COST) is up 12% since January, while General Mills Inc. (GIS) has added 20%. Both stocks carry A grades from S&P.
Several large-cap technology stocks have transitioned to higher-quality stocks in recent years as their earnings have stabilized and some now pay dividends. Financial stocks, meanwhile, have seen the biggest improvement in quality over the past five years.
“A lot of the initial risk rally hasn’t been quite in full force this whole period,” said Ms. Carey Hall, referring to the S&P 500’s gains slowing to 3% in February from nearly 8% in January. “We’re seeing and expecting higher volatility around these macro events and quality stocks are where you would want to position yourself.”
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