Get Ready for the Market's Sugar High to End

At this point in a recovery—when anxiety is on the rise because the economy and stocks have been advancing for years and the Fed is about to raise rates—"investors often seek shelter in quality," says Mark Freeman, chief investment officer at Westwood Holdings. That usually means companies with stable earnings and reliable (though not necessarily dazzling) growth.

Yet instead of favoring the Steady Eddies, Wall Street still has a taste for flashier fare. The S&P 500 Low Quality Rankings index—made up of headline-grabbing companies such as Amazon.com and Salesforce.com, both fast-growing firms that are having trouble generating reliable profits—has beaten high-quality stocks in four of the past six years.

While it's normal for speculative parts of the market to lead the way coming out of a bear market, as in 2009, the fact that they're still outperforming after more than six years is rather unusual.

This is especially true because high-quality shares generally do better over long periods. The Leuthold Group ranks the 1,500 largest stocks it tracks based on quality measures. Since 1986 the top 20% of shares based on quality rankings have generated annualized returns of 13.1%, vs. 9.7% for the lowest-quality stocks.

What's more, market and economic factors are shifting now and could soon give high-quality stocks a new tailwind.

Why Tastes Could Change

The Fed factor. For years the Federal Reserve's effort to keep a lid on interest rates to spur the economy has benefited lower-quality companies that rely on debt to finance their operations. For starters, heavily indebted corporations have been able to refinance their debt on the cheap while borrowing greater amounts at attractive rates.

At the same time, cheap money has encouraged investors to take risks and chase higher returns, pointing them in many cases to lower-quality stocks offering fatter yields, notes John Fox, research director at FAM Funds.

That's a gambit that has paid off—at least until now. "As the Fed begins to raise rates, the equation should change," says Fox. After all, investors may sour on low-quality stocks once cheap money dries up.

The 800-pound bear in the room. Something else to keep in mind is that this bull market has already run 2½ years longer than the typical rally—and has produced more than double the typical bull's gains. So it's not a stretch to think that equities are due for a pullback.

High-quality stocks are likely to lose less when the next downturn or bear market strikes, as the chart below shows. And while "it's not always obvious, generating the highest excess return in periods when the market is down is how you can outperform over the long term," says Brian Smith of Atlanta Capital Management, which invests in high-quality stocks.

How to Build a Moat

It used to be that fund investors seeking quality stocks had to go with actively managed portfolios such as the Yacktman Fund , which generates strong long-term returns by focusing on stable cash-generating cows.

Today there are several lower-cost index funds that cater to this strategy. For instance, PowerShares S&P 500 High Quality ETF tracks blue-chip stocks with the most reliable earnings and dividend growth. When the market has been on the rise during the past five years, this ETF has managed to nearly keep pace. And when the market has fallen during that stretch, it has lost 17% less than the benchmark.

Market Vectors Morningstar Wide Moat ETF is another fund that will give your portfolio a tilt toward quality. The ETF tracks an index that focuses on the 150 or so companies that Morningstar analysts believe have strong sustainable competitive advantages, and thus are well positioned to churn out reliable earnings and profitability growth. Each quarter the index is reconfigured to hold the 20 stocks in this group that are trading at the steepest discounts.

Current holdings include Exxon Mobil and Berkshire Hathaway. The ETF's 4% gain in the past year is less than half that of the S&P 500. But in 37 of the past 38 five-year rolling periods, this index has beaten the S&P 500.

And ultimately, isn't that the best gauge of quality?

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