High-quality stocks - and good buys to boot

If you want high quality at a fair price, the Canadian stock market is the place to shop.

Despite the market turmoil that has fuelled a flight to quality among investors around the world, many of Canada's highest-quality stocks and sectors remain surprisingly affordable even as they shield investors from the worst of the market's declines.

An analysis by The Globe and Mail found that 16 stocks on the S&P/TSX composite index rate a "high quality" score (A- or better) under Standard & Poor's quality ranking system, which measures consistency of both earnings growth and dividend growth over the past 10 years. These stocks have outperformed the overall market in the past 12 months, posting a median price gain of 2.1 per cent compared with a decline of 4.4 per cent for the index as a whole.

However, the average price-to-earnings (P/E) ratio among these high-quality stocks, based on consensus earnings forecasts for the next 12 months, is 13 – actually slightly less than the 13.6 for the S&P/TSX composite. That suggests that their strong price performance hasn't been a function of investors awarding them higher valuations in risk-averse times, but rather is based on their superior, or historically more reliable, prospects for earnings growth.

The findings are similar to those of Brockhouse Cooper macro strategist Pierre Lapointe and financial economist Alex Bellefleur, who recently looked at both Canadian and global high-quality stocks based on a different set of "quality" criteria – high return on equity, low debt leverage, and earnings stability.

"Contrary to the rest of the world, Canadian investors do not pay a premium for quality stocks," Mr. Lapointe and Mr. Bellefleur wrote in a research paper. "For this reason, we would conclude that Canadian quality stocks are not expensive."

Nowhere is that more evident than in Canada's financials sector, the single biggest segment of the Canadian stock market.

The sector is off nearly 5 per cent in the past 12 months, despite offering some of the highest-quality scores and dividend payouts of any segment of the Canadian market. The industry's P/E is a paltry 11.4 – ranking it near the bottom of the Canadian market's 10 major industry sectors.

Mr. Lapointe said the comparatively healthy Canadian financials group has been tarred with the same brush as troubled banks in Europe and the United States.

"I think there was a global shock wave that has affected all financials – even the ones that are sound. It's been unfair to the Canadian banks," he said in an interview. "I consider [the Canadian financials sector]very cheap, for a very sound financial system.

"It's a 'buy' at this point."

On the other hand, The Globe and Mail's analysis does reveal that in the traditionally defensive segments of the market – such as utilities, consumer staples and railroads – investors have been paying higher premiums to own some of the highest-quality names in the country. Many of these defensive names now have elevated P/E valuations – not only relative to the overall market, but even compared with other high-quality stocks.

These high valuations are most extreme in the utilities sector – perhaps the most defensive of all the traditional defensive market segments. Utilities have the highest average S&P quality rating of any segment of the S&P/TSX composite – and, by far, the highest P/E ratio. Safety-conscious investors, drawn to the sector's generous dividends, are now paying the steepest valuations in 2½ years to get them.

The utilities overload was also evident in Standard & Poor's own recent analysis of top-quality stocks in the U.S. market. Chief equity strategist Sam Stovall ran a screen to identify S&P 500 stocks that had quality rankings of A- or better, high dividend yields, but scored high on overvaluation measures and had had consensus analysts' recommendations of "hold" or worse. He found only 15 stocks that qualified; nine of them were utilities.

"I do think that these could easily get left in the dust by more attractively valued issues," he said.

S&P's Canadian Gems

Top Quality Stocks: S&P/TSX Composite

Quality rankings by sector – S&P/TSX composite

*S&P only ranks companies for which it has a 10-year earnings and dividend history.

Source: The Globe and Mail, Capital IQ, Bloomberg