A basic investment concept is to that high quality stocks fare better in down markets than low quality stocks, and therefore in late stages of a Bull market with generally fully valued stocks, tilting equity allocations toward high quality is prudent.

Accordingly, we set out to identify high quality stocks.  We know that sources such as S&P and ValueLine render quality ratings, but they are each a “black box” to a great extent, and we wanted to test quality using some other criteria as well.

We made the assumption that high quality could be identified by:

• trading liquidity
• strong balance sheets
• revenue growth
• long unbroken strings of dividend payment and increase
• wide moats against competition.

With those conceptual criteria in mind, we applied these specific filter criteria to all stocks traded in the United States:

• Wright’s investment grade rating minimum “BBB4″ (see ratings description) for liquidity, financial strength, profitability and growth, based on 32 factors (577 passed filter)
• Member David Fish’s Dividend Champions, Challenger or Contenders (“CCC”) – stocks that paid and increased dividends each year for at least 5 years; some did for decades (543 passed filter)
• Morningstar “Wide Moat” designation (258 passed filter)
• Revenue growth over each of 5, 3 and 1 years at least 3% (1796 passed filter)
• Dividend growth over each of 5, 3, and 1 years at least 3% (657 passed filter)
• Four part Balance Sheet  filter (1454 passed filter)

Four part Balance Sheet filter:

• Tangible equity increased at minimum 3% annualized rate from 5th prior fiscal year to most recent completed fiscal year
• Total Liabilities/Tangible Assets not more than that ratio 5  fiscal years ago
• Current Ratio >= 0.9
• Quick Ratio >=0.7

To understand the size of the universe we filtered, consider these sources with more than a combined 8,500 stocks:

• NYSE has 4,668 listings (almost entirely stocks)
• NASDAQ has 2,735 stocks
• NYSE/AMEX has 425 listings
• OTC BB has 836 stocks

From that universe, when we applied all of the criteria simultaneously, only 9 stocks passed, which we called our highest quality scenario.

We cross-referenced our list with quality ratings from S&P and from ValueLine, and found agreement.  The difference is that our list is much shorter than their lists.  Our criteria are more restrictive than those for S&P and ValueLine, resulting in the limited number of selections.

Highest Quality Scenario (9 stocks):

Pass All Filter Criteria

If we did not apply the Balance Sheet criteria, but applied all of the others, 18 stocks stocks in addition to the highest quality 9 passed the filter.  These 18 stocks also substantially agree with quality ratings from S&P and ValueLine.

Best Performing Scenario (18 stocks):

Pass all criteria except Balance Sheet

If we required only the Wright’s investment grade rating, the Dividend CCC membership, and the Morningstar Wide Moat, there were an additional 38 stocks, for a total of 65 out of over 8,500 that passed some level of our high quality screen. A few of the stocks in this last group had only average quality ratings from either S&P or ValueLine, but most were high quality by those two independent sources as well.

Of those last 38, there were 17 that passed 1 or more of the additional criteria; and 21 that passed only the three minimum criteria — however, those 3 minimum criteria are quite important and powerful as they reduced over 8,500 stocks to merely 65.

Let’s look into the the 27 stocks in the top group of 9 and second group of 18 high quality stocks.

If the 27 stocks where purchased in equal weights 10 years ago (as of June 30, 2014) and then rebalanced monthly — as might be done in a tax exempt or tax deferred account, but probably not in a taxable account — this chart compares the level of value accumulation of the S&P 500 versus the value accumulation by the 27 high quality stocks.

Basically, the blew the doors off of the S&P 500.  A criticism of this backtest is the benefit of hindsight.  Stocks that have only paid and increased dividends for 5 to 9 years as of today, would not have been selected 10 years ago based on the filter criteria, and their revenue and growth over the past 5, 3 and 1 years may not resemble those stats 10 years ago.

Let’s look at that in a more granular way to see recent periods where the filter is more likely to have selected these stocks.

This histogram shows how a monthly rebalanced, equal weight portfolio would have done versus the S&P 500 on a quarter-by-quarter basis.

Over the past 3, 2 and 1 years, the 27 stocks would have outperformed, but during this recent melt-up they generated less alpha than in prior periods.  Our hypothesis is that in a correction or worse, they would be better relative performers.

Let’s look now at their risk adjusted returns through the lens of Sharpe Ratios.

They have higher volatility than the S&P 500 as an equal weighted group, but superior risk adjusted returns.  The higher volatility, which is not major in significance, may be the result of a less diversified portfolio than the S&P 500.

Before, we move on to a look at the performance of the different subgroups of the 65 filter survivors, here is a high level view of the 27 by market-cap, style, and economic sensitivity.

They are large-cap and mid-cap, growth or value/growth blend by style; with a balance of cyclical, defensive and moderately economically sensitive stocks.  The standout data point is that small-caps didn’t produce any survivors.

Now let’s look at different filter survivor sub-groups.

Referring to the selection process as scenarios, we have identified 5 slices of the survivors:

• Scenario I: Dividend CCC, Wright investment grade and Morningstar Wide Moat only (23 stocks)
• Scenario II:  Scenario I criteria plus Balance Sheet criteria (15 stocks)
• Scenario III: Scenario I criteria plus revenue and dividend growth criteria (18 stocks)
• Scenario IV: Scenario I plus revenue and dividend growth and Balance Sheet criteria (9 stocks)
• Scenario V: All stocks in Scenarios I-IV (65 stocks)

This first table calculates the “price only” IRR of each scenario of equal weighted stocks in  “buy and hold” portfolios (no rebalancing this time).

Scenario IV (all criteria met) is the superior price performer in all periods including 10, 7, 5, 3, 1 years and 6 months year-to-date 2014.

Scenario III (revnue and growth requirement, but not Balance Sheet) came in second and  outperformed the S&P 500  for 10, 7, 5 and 3 years; but fell behind the S&P 500 over that 1- year and 6-month periods.  In that 1-year and 6-month periods, Scenario II (Balance Sheet requirement, but not revenue or dividend growth) pulled into second place, beating the S&P 500.

Is the slight rotation from growth focus to Balance Sheet focus related to a concern about the impact of expected interest rate rises?

As an alternative way to examine the same price-only IRR data, this table presents the return spread between the Scenarios and the S&P 500.

Here is a table of 7-year and 5-year annualized growth of sales, reported earnings per share and dividends.

In this case, Scenario III (the revenue and dividend growth factors) understandably have somewhat stronger growth characteristics.  There has been a huge earnings recovery in the S&P 500, but that includes the effect of coming out of a large earnings hole.  The high quality stocks have lower 5-year earnings growth, because they did not have the earnings hole experienced by the S&P 500 in its entirety.

Looking at valuation (as of June 30, 2014), the high quality stocks have higher valuation multiples, but when we get to the PEG ratio (forward P/E divided by estimated 5-year forward earnings growth rate), the valuations for Scenarios II, III and IV are  in the reasonable range (basically 1x to 2x).

Scenario I (Dividend CCC, Wright’s investment grade, and Morningstar Wide Moat alone, is expensive  with a PEG of 3.63x (lacks sufficient growth).

These two tables present valuation data for the 9 and 18 stocks discussed above.

If you are interested in the current technical condition, potentially for deciding when to enter one or more of the stocks, you might want to be aware of opinions such as those from BarChart or StockCharts.com.

Not all of these are in good technical shape, but from a fundamental perspective most of these are probably a pretty good go-to list for high quality.

Here are links to each with technical ratings (change the symbol on the linked pages for the security you want to see):

• BarCharts
• StockCharts (see SCTR, StockCharts Technical Rating in top panel)