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A+ Doesn’t Always Make the Grade

May 2014

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Bear Stearns was one. Freddie Mac and American International Group (AIG) were too, once upon a time. Each of these companies maintained a quality rating of “A+” by Standard & Poor’s (S&P) just prior to the Great Recession. Today, only AIG is still around. So what’s in a quality rating and how should investors think about them?

Since 1956, Standard & Poor’s (S&P), purveyors of the widely-used S&P 500 Index, assigns stocks a rating for quality based on the businesses’ earnings and dividend history. To be clear, these are not credit (bond) ratings, rather they are measures of earnings and dividend patterns that are adjusted for changes in growth, stability, long-term trends and cyclicality. S&P then translates these adjustments from a final quantitative measure into a qualitative letter grade for a company’s stock, from A+ (highest) to C (lowest). For more information about S&P’s methodology, please visit this page.

Like many measures available to investors (e.g., Morningstar’s star ratings or Value Line’s Financial Strength Ratings) S&P’s quality rating system is intended as an informative tool, not a decision-making tool. In the investment industry it is generally thought the higher the quality rating, the higher the perceived safety of a company’s stock, and the lower the quality rating, the higher the perceived risk of a company’s stock. Let’s challenge the ideas behind these perceptions.

The chart below contrasts the total returns for two portfolios over the last two market cycles. These cycles span 18 years and encompass the better part of at least one full generation’s investing experience. The first portfolio (blue line) contains all the B+-rated companies in the S&P 500 while the second (red line) contains only the A+-rated companies in the same S&P 500.

Total Return of S&P 500 B+ vs A+ Rated Companies

Although the A+ rated companies held up better during each recession (i.e., flight to quality), the advantage of this protection is marginalized when you consider the entire 18-year investment experience. Put simply, B+ rated companies generated a higher compound annual growth rate (CAGR) in total return of 13%, compared to their supposed higher-quality A+-rated counterparts that generated an 11% total return CAGR. In fact, B+-rated companies generated a higher total return CAGR than every other quality rating group (A+, A, A-, B, B- & C) over this time period.

Why did B+ rated companies generate higher returns? Perhaps it’s because they grew earnings at a faster clip. The chart below illustrates this.

Earnings Per Share Growth of S&P 500 B+ vs A+ Rated Companies

The growth in earnings per share (EPS) for B+-rated companies from 1995 to the present is 11%. For A+-rated companies, the CAGR is 9%. And once again, B+-rated companies generated a higher EPS CAGR than every other quality rating group over this time period. So, if you believe as we do that a company’s earnings are the primary driver of stock prices over time, this historical outcome makes sense.

On a pragmatic level, investors should recognize that the S&P quality ratings, like other measures of quality, are backward-looking. Because markets are thought to discount future events, we believe investors should try to focus their attention on analyzing the level, pace, and durability of a company’s future earnings growth prospects in their assessment of quality rather than on a perceived level of safety associated with a letter “grade”.

Was S&P “wrong” to assign AIG, Freddie Mac, or Bear Stearns an A+ rating? Of course not. Based on S&P’s methodology and each company’s historical record, those companies may well have earned their rating. But we believe investors should pay just as much attention to where the quality rating is headed as to where it’s been. That’s why we believe fundamental, bottom’s-up analysis is a critical factor in generating successful outcomes.

As stewards of capital we don’t believe high quality and faster growth are mutually exclusive investment concepts. And, since we’re talking about letter grades, let’s just say we believe over the long-run it pays to do your homework. We remain focused on understanding the current trends in fundamentals because it gives us the best probability for success.