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Equity Perspectives

Lord Abbett portfolio managers focus on the quality philosophy of three distinct styles growth, value, and calibrated dividend growth.

Since the financial crisis of 2008–09, the stock market, as measured by the S&P 500® Index,1 has more than doubled—but it's been a rocky ride, with speculative stocks leading the way and quality stocks lagging. Will quality stocks, which have, historically, outperformed during periods of market distress, start to lead soon? F. Thomas O'Halloran, Lord Abbett Partner & Director of Multi and Small Cap Growth; Deepak Khanna, Lord Abbett Partner, Portfolio Manager of Large Cap Value and Multi Cap Value; and Rick Ruvkun, Lord Abbett Partner & Director of Calibrated Equity Management, offer their different perspectives on quality.

What is it about the concept of quality stocks that stirs so much ambiguity? Is it because the term is bandied about so often that the definition blurs? Or is it because you hear it from pundits in different contexts? Both, perhaps, although Standard & Poor's has published quality rankings that reflect the long-term growth and stability of a company's earnings and dividends since 1956.2

For a more recent intellectual framework, consider an April 2013 report by the Leuthold Group that applies a multidimensional metric to defining quality.3 (See Figure 1.) The first measure Leuthold cites is top-line quality, meaning companies that generate stable and growing revenues. The second is bottom-line quality, meaning companies with stable and growing earnings and cash flows, as well as a predictable earnings stream. Then there's balance-sheet quality, since lower leverage generally lowers the risk of bankruptcy. And last is the quality of stock returns, with particular attention to low price volatility and the level and growth of dividends.


 
Figure 1. Defining Quality Can Blend Four Elements
Annual as a percent of outstandings, seasonally adjusted

Source: The Leuthold Group.

 

According to Ned Davis Research, low-quality stocks, as denoted by companies with 'C' ratings in the S&P Quality Rankings, outperformed higher-quality stocks (with 'A' and 'B' rated credit by Standard & Poor's) for four years since the depths of the financial crisis. (See Chart 1.) But following recent market volatility, some investors may wonder when higher-quality stocks will begin to lead.


 
Chart 1. Low-Quality* Stocks in the S&P 500® Index Have Dominated Since March 2009
Cumulative performance of companies in S&P 500 Index by S&P Quality Ranking**

Source: Ned Davis Research. Daily data from March 9, 2009–July 31, 2013.
*Low quality in this example refers to the stock performance of S&P 500 companies whose credit is 'C' rated by Standard & Poor's. Lower-quality stocks may be more volatile and less liquid than higher-quality stocks.
Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment.
The index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.
** The S&P Quality Rankings System attempts to capture the growth and stability of earnings and the dividends record with a single rank. The rankings are based on per-share earnings and dividend records of the most recent 1 0 years. The rankings are based on the following scale: A+ = Highest; A = High; A- = Above Average; B+ = Average; B = Below Average; B- = Lower; C = Lowest; D = In Reorganization; LIQ = Liquidation.

 

Of course, high-quality stocks do not always represent the best investment opportunities. As the Leuthold Group put it, "Given our desire to arrive at a stock quality metric that protects investors during periods of unforeseen adversity [see Table 1], we favor companies trading with low levels of volatility and whose total return streams include dividends as a growing component."4


 
Table 1. High-Quality Stocks Historically Have Outperformed Low-Quality Stocks During Bad Markets

Source: The Leuthold Group, which identified the six periods of market stress based on S&P 500 performance. High quality in this table refers to the top quintile of companies in the S&P 500 Index in the screen described in Figure 1. Low-quality stocks in this case refer to the bottom-quintile companies in the S&P 500 Index in that screen.
Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment. The index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.

 

Lord Abbett's approach to quality is a study in differing investment styles, grounded in prudent diversification and risk guidelines. For illustration purposes, this article focuses on the quality philosophy of three distinct styles: growth, value, and calibrated dividend growth.

A Growth Perspective
As a former hockey player, F. Thomas O'Halloran appreciates the importance of hard work and quick responses. And as a passionate golfer, he has a good record of shooting straight. After he joined Lord Abbett in 2001 as Technology Analyst, it was just a matter of time before he started managing the Lord Abbett Developing Growth Fund in March 2003 and was named Partner later that year. Now he is a Portfolio Manager for all of Lord Abbett's growth equity strategies, and he manages three equity growth funds.

O'Halloran's team members focus on what they believe are the best growth stocks5 in their respective sectors. But instead of using a "quality" moniker, the adjective they use most often is "special." "We believe these companies are so much better than average that they're well worth taking the risk that is often present in their valuations because they have so much more growth potential," O'Halloran said. "And to find these, we need to have a very rigorous process and engage in very intensive fundamental research because the key value here is differentiating those special names out of a vast universe. That is the real skill."

Still, there is the risk that such special companies become so popular that their stocks plunge on disappointing news or fears that their premiums have become too rich. But O'Halloran doesn't mind taking some valuation risk while seeking to garner the extra return. He manages that risk through diversification, best-of-breed selection process, and a disciplined selling process.

"We don't invest in companies; we invest in stocks," he said at a recent conference for registered investment advisors. "Of course, [stocks] go through cycles, and you want to own them when they're going up, and you want to be out of them, or not own very much, when they're going down."

A former prosecutor who started his financial career 27 years ago, O'Halloran looks for companies with four key attributes: 1) they tend to have a very sound business model that gets more profitable as it gets bigger; 2) they're run by confident, talented people who are credible (he therefore avoids people who have shortchanged investors in the past); 3) they generally operate in an industry that is healthy; and 4), the quality companies he seeks should be market leaders or ones gaining meaningful market share.

Once a company meets those criteria, O'Halloran will look at its revenue and earnings growth to be the primary driver of stock outperformance.

When the fundamental prospects of a business and the technical profile of a stock improve in tandem, the team might double its position on a stock after a significant jump and maintain that position if rigorous research suggests there is further potential for appreciation. The key is decisive action once that momentum turns.

For example, if a company made an acquisition in unfamiliar territory, or its business model deviated from its core competency, O'Halloran's team would likely cut its position or eliminate it altogether. What if a stock is extremely expensive or way too ahead of itself? The response would be similar; but as O’Halloran is quick to point out, there are regular exceptions to that rule, when overarching fundamentals present a compelling argument to maintain a position.

The Value Perspective
Deepak Khanna joined Lord Abbett in 2000, covering health care, where he was particularly prescient on pharmaceuticals and biotechs. His belief is that companies that have products originating from their own research and development efforts and that address "unmet needs" ultimately command a higher premium versus peers. He also covered the services and medical technology subsectors of the healthcare industry. This broad coverage gave him good perspective and allowed him to spot trends early that shaped his investment decisions, especially in the managed care and caregiver sectors. Since 2007, he has been a Portfolio Manager on the multi-cap value strategy and took over as lead Portfolio Manager in 2012. (Sean Aurigemma joined that strategy in 2010.)

As with O'Halloran's multi-cap growth strategy, Khanna can go up and down the market-cap spectrum to find quality companies. That "go anywhere" strategy offers a bigger opportunity set than single-cap funds in terms of the number of available stocks, as well as a wider selection within industries.

For Khanna and his team, characteristics of quality companies include leading market positions, solid financials, historical profitability, strong management track record, and long operating histories. This smaller subset of quality companies is assessed to determine whether there are catalysts that may lead to improved profitability and earnings power that may be underappreciated or not yet recognized by the market. (Examples of catalysts could include a new product launch, a management change, or a significant capital deployment.) Of particular interest are companies whose multiples—either on earnings, cash flow, book value, or sales—are at historically low levels.

When it comes to fundamental analysis, Khanna’s team spends a lot of time getting to know the company’s business units and management. They try to appreciate why the company has been successful and has grown its profitability, not necessarily each and every period, but over time, given economic, competitive, and product development cycles that influence rate of change. The ultimate goal is to find companies that have the assets, resources, and management to weather those cycles and emerge even stronger.

Put another way, Khanna's team tries to emulate the "win by not losing" strategy first articulated by investment icon Charlie Ellis (who was once the long-time managing partner of Greenwich Associates and chairman of the CFA Institute). While focusing on absolute downside risk in each stock they buy, the team's emphasis on high-quality, seasoned company value stocks also tends to reduce the strategy's downside risk.

All that emphasis on quality has helped Lord Abbett's multi-cap value strategy achieve some of the best upside/downside capture ratios6 in the industry by finishing in the top quartile over the last three- five-, and 10-year periods as of July 31, 2013, according to Morningstar.

[Of course, there is no guarantee the strategy will perform in a similar manner in the future, and it is possible that during any given time frame within these periods the strategy may have had negative performance.]

Dividend Quality
One might wonder why many investors have shifted from lower-quality stocks to higher-quality stocks at this point of the market cycle. Aside from the fact that higher-quality stocks have historically outperformed lower-quality stocks (according to Standard & Poor's), one big reason for the shift is flagging confidence in economic growth around the world. And that has made companies that can achieve healthy revenue gains in a sluggish environment, and even healthier income growth, particularly attractive, especially if they have a significant record of growing their dividends.

According to Ned Davis Research, concentrating on dividend growers has generated superior long-term returns over the last 40 years. (See Chart 2.)


 
Chart 2. U.S. Dividend Growers Have Generated Long-Term Return
Growth of $10,000 in S&P 500 Index (01/31/1972–09/30/2012)

Source: Ned Davis Research, Inc. Copyright © 2013 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All rights reserved. See NDR disclaimer at www.ndr.com/ copyright.html. For data vendor disclaimers, refer to www.ndr.com/vendorinfo.
Returns are based on subcomponents of the S&P 500 Index, equal weighted on a total return basis, January 31, 1972–September 30, 2012.
Past performance is no guarantee of future results. The chart is based on an equal-weighted geometric average of the historical total return of dividend-paying and non-dividend-paying stocks for the period January 31, 1972–September 30, 2012. Dividend growers, payers, nonpayers, and cutters are subcomponents of the S&P 500 Index. The categories are created using actual annual dividends to identify dividend-paying stocks and is rebalanced annually. The dividend policy for each stock is determined on a rolling 12-month basis. The periods shown do not represent the full history of the S&P 500 Index.
For illustrative purposes only and does not represent any specific Lord Abbett account or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.
Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

In the United States, such dividend growers are typically established blue-chip companies—companies with stable business models, strong balance sheets, and management teams committed to shareholders that have been able to grow their earnings in most market environments. They also tend to have a higher profitability and higher dividend yield7 than the average stock in the S&P 500 Index.

Another quality of consistent dividend growers is that such companies have often provided investors with a lower risk profile than the broader market (as represented by the S&P 500 Index) between January 31, 1972, and June 30, 2013. In that period, companies with a record of growing their dividends proved less volatile, with a standard deviation8 of just 16.17% versus 16.96% for the stocks that pay any type of dividend in that index, according to Ned Davis Research.

Then there is the substantial contribution of both growing and reinvested dividends to total return. A seminal study by three professors from the London Business School found that over any significant period, reinvested dividends account for at least 40% of total return. "While year-to-year performance is driven by capital appreciation, long-run returns are heavily influenced by reinvested dividends," the authors said. "The longer the investment horizon, the more important is dividend income."9

All of which helps to explain why the Lord Abbett Calibrated Dividend Growth Fund (comanaged by Lord Abbett partners Rick Ruvkun and Walter Prahl) focuses on the strongest and largest U.S. companies that have an impressive history of increasing their dividends.

What kind of dividend growth? "Rather than focusing on yield, which can result in somewhat higher risk, in this fund we look for companies with a consistent record of raising their dividend—usually for the last 10 consecutive years," said Ruvkun, Lord Abbett Partner & Director of Calibrated Equity Management. "That approach seeks to produce a portfolio of stocks with the type of characteristics that many income-oriented clients prefer: higher quality, consistent dividend growth, and lower volatility."

Of course, investors’ perceptions of stocks may vary according to their risk tolerance, objectives, and time horizon. But that just underscores the need for active management with a record of assessing quality in growth, value, and dividend growth in all kinds of markets.

—Reported by Steve Govoni


1 The S&P 500 ® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. The index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.
2 Standard & Poor's says its Quality Rankings System is computed for earnings and dividends and then adjusted by a set of predetermined modifiers for changes in the rate of growth, stability within long-term trends, and cyclicality. Adjusted scores for earnings and dividends are then combined to yield a final ranking.
3 According to the Leuthold Group, investors have generally been rewarded for holding high-quality stocks in their portfolios regardless of sector composition. "The outperformance of high-quality stocks is quite variable over time, with periods of market stress being the most advantageous from a relative performance basis," said Leuthold analysts Jun Zhu and Eric Weigel. Low-quality stocks are generally defined as companies that tend to have a lot of debt, poor balance sheets, and inconsistent and unpredictable earnings. Such companies also would run the greatest risk of going bankrupt.
4 Jun Zhu and Eric Weigel, "Quality as an Investable Stock Selection Concept," Inside the Stock Market, The Leuthold Group, April 2013.
5 A growth stock is generally one whose earnings appear to be moving up smartly, but whose price seems high when measured by indicators such as the price-to-earnings (P/E) or price-to-book (P/B) ratio. The P/E ratio (also known as the multiple) reflects how much a stock costs relative to its earnings. It is calculated by dividing the current stock price (the P) by the current earnings (the E). A value stock typically has a lower P/E and P/B and lower earnings growth as well.
6 According to the New York State Society of Security Analysts, upside and downside capture ratios are commonly used to determine how much an investment participates in the upside or downside of the market. Upside capture compares an investment's performance against its benchmark during periods when the benchmark's performance is positive, while downside capture compares the investment's performance against the benchmark during periods when the benchmark's performance is negative.
7 Dividend yield is equal to the dividend divided by the stock price. Dividend yield is one measure of a stock's value. A high dividend yield may indicate that a stock is relatively inexpensive.
8 Standard deviation is a widely used statistical measure of risk. Simply put, the higher the standard deviation, the more the portfolio's returns vary from the portfolio's average return, which means greater volatility.
9 Elroy Dimson, Paul Marsh, and Mike Staunton, Credit Suisse Global Investment Returns Sourcebook 2009, February 2009. The London Business School authors are considered global authorities on long-run stock, bond, bill, and foreign exchange performance.

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RELATED FUND
The Fund seeks to deliver total return by investing primarily in stocks of large U.S. companies that have a history of increasing their dividends.
RELATED FUND
The Fund seeks to deliver long-term growth of capital by investing primarily in stocks of U.S. companies.

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