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Feb. 7, 2014, 3:01 p.m. EST

10 quality stocks to beat a declining market

Opinion: Looking for companies that hold their own in a correction

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By Mark Hulbert, MarketWatch

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Perhaps the biggest cautionary tale about the dangers of overpaying for quality comes from a group of stocks in the early 1970s that were known as the Nifty Fifty. These were established companies with long records of earnings growth and dividend increases. Though the term wasn’t used at the time, they in many ways resembled what is now known as the “quality” category.

The Nifty Fifty were touted as “one decision” stocks that could be held through thick and thin, and investor enthusiasm led them to have sky-high valuations. Jeremy Siegel, a finance professor at the University of Pennsylvania’s Wharton School, calculates that their average P/E at the bull-market high in December 1972 was 41.9 — more than double the S&P 500’s 18.3.

These stocks were decimated by the 1973-74 bear market, and it took them years to recover. It wasn’t until the early 1990s that a Nifty Fifty portfolio bought in December 1972 was ahead of a portfolio that had done nothing but invest in short-term certificates of deposit, according to Larry Swedroe, director of research at Buckingham Asset Management in St. Louis, which has $6 billion in assets.

This awful performance isn’t an indictment of quality stocks per se. Instead, it’s an object lesson in the importance of not overpaying.

No stocks, even those of high quality, “are so good that you should be willing to pay any price for them,” says James Montier, a visiting fellow at the United Kingdom’s University of Durham and a member of the asset-allocation team at Boston-based GMO, an investment firm with $108 billion under management.

Though the average quality stock today isn’t as overvalued as the Nifty Fifty were in 1972, it is pricier than the overall market. That can make it difficult for fund investors to buy undervalued quality stocks.

Consider the iShares MSCI USA Quality Factor exchange-traded fund /zigman2/quotes/207688564/composite QUAL +2.45%  , which invests in stocks that score highest on a quality ranking created by Morgan Stanley Capital International, which favors companies with a high return on equity, stable year-over-year earnings growth and low financial leverage. It has an annual expense ratio of 0.15%, or $15 per $10,000 invested.

The ETF’s biggest holding right now — Google /zigman2/quotes/205453964/composite GOOG +2.96%   — has a P/E ratio of 29, based on trailing 12 months earnings. The average P/E of all stocks this ETF owns is 23.1, according to iShares. The S&P 500’s P/E, in contrast, is 17.3. Another indication of the rich valuation of the stocks the ETF owns is their average price/book ratio, which is calculated by dividing a stock’s price by its per-share book value — a measure of net worth. The average price/book ratio of the ETF’s stocks is 6.6, versus 2.5 for the S&P 500.

Another ETF that invests in quality stocks is the PowerShares S&P 500 High Quality Portfolio /zigman2/quotes/207918096/composite SPHQ +2.03%  , with charges annual fees of 0.29%. The average P/E of the stocks it holds is 18.4, and its average price/book ratio is 3.5.

Pointing out these relative valuations isn’t a criticism of these ETFs, since they are constructed to reflect the average performance of various groups of quality stocks — and the criteria for defining quality don’t take price into account. But the funds’ composition does make them a less-than-ideal choice for investors interested in purchasing stocks that are both high-quality and undervalued.

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Mark Hulbert is the founder of Hulbert Financial Digest in Chapel Hill, N.C. He has been tracking the advice of more than 160 financial newsletters since 1980. Follow him on Twitter @MktwHulbert.

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Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD...

Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD became a service of MarketWatch in April 2002. In addition to being a Senior Columnist for MarketWatch, Hulbert writes a monthly column for Barron’ and a column on investment strategies for the Journal of the American Association of Individual Investors. A frequent guest on television and radio shows, you may have seen Hulbert on CNBC, Wall Street Week, or ABC’s World News This Morning. Most recently, Dow Jones and MarketWatch launched a new weekly newsletter based on Hulbert's research, entitled Hulbert on Markets: What’s Working Now.

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