Higher-Quality Stocks Show Signs of Leadership as ‘Junk Rally’ Fades

By Mike Rode, CFA
MAY 07 | 2021
Looking up into a canopy of trees.

Value stocks began their long-awaited rally in November 2020 following the news of positive results in Pfizer/BioNTech and Moderna COVID-19 vaccine trials. They rallied further in response to the removal of political uncertainty after the January 2021 U.S. Senate runoff election in Georgia.

These tailwinds helped value stocks outperform growth stocks by approximately 10% in the first quarter, after underperforming growth by nearly 36% in 2020.{sup}1{/sup}  Notably, the stocks of lower-quality companies—so-called “junk” stocks—whose businesses depend more on strong or improving economic conditions have dominated the initial stage of the value rotation and economic recovery. These are the same companies that suffered the most when the pandemic shut down the global economy.

Share prices have not risen as sharply for companies that were better equipped to withstand that severe economic downturn. This situation has provided a headwind for the relative performance of investment managers that focus their portfolios on these higher-quality firms demonstrating solid fundamentals, including strong balance sheets, low levels of debt, leading market positions and forward-thinking management teams. These companies do not require economic tailwinds to succeed and tend to be resilient, cash-generating businesses that can compound investment returns over time.

Analysis Confirms the Junk Rally

Conducting a factor analysis is one way to quantify market behavior by identifying factors or characteristics the market rewards or penalizes. See Figure 1.

According to Credit Suisse, stocks that performed best in the first quarter included those with low price-to-earnings (P/E) ratios. A relatively low P/E is a metric we associate with a lower-quality company. Companies that performed the worst during the COVID-19 downturn (as measured by their 52-week drawdowns) also performed well in the first quarter.

Stocks that performed worst during the first quarter included those with lower leverage (debt) and high returns on assets (ROA). We associate both factors with higher-quality companies.

Figure 1 | Lower-Quality Stocks Drove Q1 2021 Performance

Lower-Quality Stocks Drove Q1 2021 Performance

Data from 1/1/2021 ˗ 3/31/2021. The S&P 500® serves as the index and investment universe. Past performance is no guarantee of future results. Source: Standard & Poor's, Thomson Financial, FactSet, and Credit Suisse.

Junk Rallies Are Nothing New

Economic recoveries and attendant junk rallies have a history of briefly resuscitating the stocks of companies whose businesses were severely challenged even before downturns. Recent examples include heavily shorted companies like GameStop and AMC Entertainment. They were on the verge of bankruptcy in 2020 but rose nearly 1,000% and 300%, respectively, in the first few weeks of 2021. 

While the phenomenon of social media-frenzied trading temporarily boosting prices of suspect stocks is new, the outperformance of lower-quality stocks following a recession is not. These periods of robust outperformance during the early stages of recovery are often followed by long periods of underperformance more reflective of deteriorating company-specific fundamentals.{sup}2{/sup}

We Expect Quality to Become More Important

We believe expectations for a recovery in 2021 may be priced in for the lowest quality companies. A March 2021 research report from Bank of America Global Research said low-quality stocks have outperformed high-quality stocks by nearly 20% since March 2020, fueled by massive monetary and fiscal stimulus.{sup}3{/sup} While these lower-quality value rallies do happen over time, historically they have shown to be short lived, and we believe over the long run higher-quality companies will outperform and with lower volatility. Another reason we are optimistic is the positive performance of high-quality stocks in March, which could potentially indicate an enduring rotation toward high quality as the global economy continues to reopen.

This reinforces what we already know based on historical data—higher-quality companies outperform over time. Our analysis shows a hypothetical investment of $10,000 in high-quality stocks would have grown to a value of nearly $236,000 over the last 25 years. A similar hypothetical investment in low-quality stocks would have grown to a value of approximately $174,000, a difference of nearly 36%. This analysis is based on S&P Quality Rankings of stocks rated B+ or better versus those rated B or worse from December 31, 1994, through March 31, 2021.{sup}4{/sup}

As the rate of economic growth returns to more normal levels, we believe each company’s underlying strength is likely to play a larger role in its stock price performance. Because markets can shift quickly, we think investors should consider how the solid fundamentals of higher-quality companies may drive stock price performance going forward.

Mike Rode, CFA
Mike Rode, CFA

Vice President

Senior Client Portfolio Manager

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Based on the Russell 1000 Growth and Russell 1000 Value indices. Year-to-date performance as of 3/31/2021.

Cornerstone Macro.

The S&P Quality Rankings System is managed by S&P Global Intelligence and attempts to capture the growth and stability of earnings and the dividends record with a single ranking. The rankings are generated by a computerized system and based on per-share earnings and dividends records of the most recent 10 years.

“Performance by Market Cap and Quality,” Bank of America Merrill Lynch, 3/31/2021.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.