You are on page 1of 38

Standard & Poors Quality Rankings

Portfolio Performance, Risk, and Fundamental Analysis

October 2005

Standard & Poors Quality Rankings


Portfolio Performance, Risk, and Fundamental Analysis

October 2005

This report was prepared by: Massimo Santicchia Director (212) 438-3934 Philip G. Murphy, CFA Director (212) 438-1368

Acknowledgements: Jim Branscome David Blitzer Roger Bos Jim Dunn Michael Fink Joshua Harari Jacqueline Meziani John Schemitsch Ken Shea

This report is published by Standard & Poors, 55 Water Street, New York, NY 10041. Copyright 2005. First Edition. Standard & Poors (S&P) is a division of The McGraw-Hill Companies, Inc. All rights reserved. Standard & Poors does not undertake to advise of changes in the information in this document. Standard & Poors has used information available in the public domain to produce this report.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

I. Executive Summary

Standard & Poors has provided Earnings and Dividend Rankings, commonly referred to as Quality Rankings, on common stocks since 1956. Quality Rankings reflects the long-term growth and stability of a companys earnings and dividends. Portfolios of stocks with high Quality Rankings outperformed the S&P 500 Index and substantially outperformed portfolios of stocks with low Quality Rankings over the 1986-2004 period. The portfolio with the highest quality (A+) outperformed the S&P 500 by about 110 basis points. Portfolio risk is lower for companies with higher Quality Rankings. On a risk-adjusted basis, the all-A portfolio outperformed the all-B portfolio by almost 300 basis points. Fundamental risk is lower in portfolios of stocks with high Quality Rankings. The portfolios exhibit stable and persistent earnings, high returns on equity, stable and wide profit margins, and low debt levels. Companies with high Quality Rankings appear less likely to engage in accounting manipulations. Over the 1986-2004 time frame, these companies reported significantly lower non-recurring items. They also have higher quality of earnings as defined by Standard & Poors Core Earnings methodology. Portfolios of stocks with high Quality Rankings provide downside protection. Over the 1986-2004 period, these portfolios significantly outperformed the S&P 500 and portfolios of companies with low Quality Rankings in times of earnings deceleration and increasing credit risk. Earnings growth for companies with high Quality Rankings is not correlated with overall corporate earnings and credit cycles. Conversely, earnings growth for companies with low Quality Rankings is highly dependent on earnings and credit cycles. Stock selection strategies based on Quality Rankings can be executed with little market impact, as stocks with high Quality Rankings exhibit high liquidity, and portfolio turnover is low.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

TABLE OF CONTENTS
SECTION I. SECTION II. SECTION III. 1.0 INTRODUCTION 3

2.0 DESCRIPTION OF THE STANDARD & POORS QUALITY RANKINGS SYSTEM 5 3.0 RISK AND RETURN ANALYSIS OF QUALITY RANKINGS PORTFOLIOS 3.1 Methodology 3.2 Risk and Return Analysis 3.3 Downside Risk Analysis 6 6 7 8 11 11 12 14 18 18 18 18

SECTION IV.

4.0 FUNDAMENTAL ANALYSIS OF QUALITY RANKINGS PORTFOLIOS 4.1 Size, Leverage, and Profitability 4.2 Growth and Profitability Analysis 4.3 Performance of Quality Rankings Portfolios in Earnings and Credit Cycles

SECTION V.

5.0 QUALITY OF EARNINGS 5.1 Quality Rankings and Standard & Poors Core Earnings 5.2 Quality Rankings and Special and Extraordinary Items 5.3 Quality Rankings and Dispersion in Analyst Forecasts

SECTION VI.

6.0 PORTFOLIO CHARACTERISTICS OF RECENT AND HISTORICAL QUALITY RANKINGS PORTFOLIOS 6.1 Quality Rankings Portfolio Characteristics and Composition 6.2 Quality Rankings Sector Makeup 6.3 Quality Rankings, Capitalization, and Growth-Value Split Analysis 6.4 Valuation Multiples Analysis 22 22 24 26 28 30

SECTION VII.

7.0 CONCLUSION

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

LIST OF EXHIBITS
Table 1 Table 2 Table 3 Table 4 Table 5 Table 6 Table 7 Table 8 Table 9 Figure 1 Figure 2 Figure 3 Figure 4 Figure 5 Figure 6 Figure 7 Figure 8 Figure 9 Figure 10 Figure 11 Figure 12 Figure 13 Figure 14 Figure 15 Figure 16 Figure 17 Quality Rankings Classification Market-Weighted Annual Returns for Quality Rankings Portfolios Equal-Weighted Annual Returns for Quality Rankings Portfolios Size, Leverage and Profitability at Different Points in Time Mean Values and Volatility of Profitability Metrics for the Period 1985-2004 Quality Rankings: Number and Percent of Total Ranked Stocks Price, Market Value and Turnover by Quality Rankings Transitional Probabilities Matrix for Quality Rankings Growth-Value Split of High-Quality (A+, A and A-) As of June 2005 Value of $10,000 Invested in All-A and All-B, C & D Portfolios Market-Weighted Returns Value of $10,000 Invested in All-A and All-B, C & D Portfolios Equal-Weighted Returns Market Betas of Quality Rankings Portfolios in Up and Down Markets Average Monthly Returns in Up and Down Markets Growth and Profitability Metrics over Time Corporate Earnings Cycle and Performance of Quality Rankings Portfolios Percentage of Companies with S&P Credit Rating of A- or Better Impact of Interest Rate on Interest Coverage Ratio of High- and Low-Quality Companies Median Percentage Difference Between Core Earnings and As-Reported Earnings Special and Extraordinary Items and Discontinued Operations As a Percentage of Operating Income for Quality Rankings Portfolios Analysts Growth Forecast Consensus and Dispersion As of December 2004 High-to-Low Quality Ratio Over Time Current Breakdown of and Trend in S&P 1500 Sector Composition of All-A Portfolio Quality Rankings Distribution by Index All-A Companies Classified As Growth or Value As a Percentage of Total Price-to-Book and Price-to-Sales Ratios for Quality Rankings Portfolios Earnings Yield for A+ and B Quality Rankings Portfolios

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

I. Introduction

A statement of actual earnings, over a period of years, with a reasonable expectation that these will be approximated in the future. The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence, and secondly because the average of a fairly long period will tend to absorb and equalize, the distorting influences of the business cycle.1 Graham and Dodd on sustainable earnings power
Standard & Poors has provided Earnings and Dividend Rankings, also known as Quality Rankings, on common stocks since 1956. These Quality Rankings capture Graham and Dodds definition of sustainable earnings power, are used in portfolio management as prudent investments, and are commonly employed in investment litigation to determine the prudence of stock investments. A long history of Quality Rankings is available, and several academic and practitioner studies have examined their informativeness and reliability2. This paper analyzes whether the prudent investment suggested by Quality Rankings is a wise investment as well. In particular, after briefly describing the mechanics of Quality Rankings, we analyze the following questions: What are the risk and return characteristics of portfolios based on Quality Rankings? How do higherquality portfolios perform in times of distress? What are the fundamental risk characteristics of different Quality Ranking portfolios? How do the fundamental characteristics of different Quality Rankings portfolios vary in different phases of the corporate profit and credit cycles?2 After analyzing the risk, return, and fundamental characteristics of Quality Rankings portfolios, we examine the relationship between Quality Rankings and several other measures of earnings quality. We show that earnings growth of higher-quality firms, as defined by Quality Rankings, is more predictable than that of lower-quality firms. We also show that companies with higher Quality Rankings appear less likely to engage in accounting manipulations. Companies with high Quality Rankings also have higher quality of earnings as defined by the Standard & Poors Core Earnings methodology. Next, we briefly examine whether high-quality stocks are glamour stocks. Our analysis shows that highquality stocks indeed have generally traded at higher multiples. Our analysis of fundamentals, however, shows that the premium in multiples for the higher-quality portfolio is justified by better fundamentals. Thus, our results show that higher-quality stocks command higher multiples and deliver higher returns. These results are different from the conventional wisdom established by previous studies on risk factors in the U.S. equity markets, and provide a new insight into the risk and return characteristics of U.S. stocks. Finally, we report characteristics of current and historical Quality Rankings portfolios. Our results show that high-quality stocks generally have greater liquidity, higher average price per share, and larger market value. In addition, Quality Rankings exhibit high stability over time. This implies that portfolio strategies based on Quality Rankings can be executed in practice.
1 Graham and Dodd (1934), p. 429. 2 Stevenson (1966), Haugen (1979), Muller, Fielitz and Greene (1983,1984), Muller and Fielitz (1987), Del Guercio (1995), Fernando,

Gatchev and Spindt (2003).

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

II. Description of the Standard & Poors Quality Rankings System3

The Quality Rankings System attempts to capture the growth and stability of earnings and dividends record in a single symbol. In assessing Quality Rankings, Standard & Poors recognizes that earnings and dividend performance is the end result of the interplay of various factors such as products and industry position, corporate resources and financial policy. Over the long run, the record of earnings and dividend performance has a considerable bearing on the relative quality of stocks. The rankings, however, do not profess to reflect all of the factors, tangible or intangible, that bear on stock quality. The rankings are generated by a computerized system and are based on per-share earnings and dividend records of the most recent 10 years a period long enough to measure significant secular growth, capture indications of basic change in trend as they develop, encompass the full peak-to-peak range of the business cycle, and include a bull and a bear market. Basic scores are computed for earnings and dividends, and then adjusted as indicated by a set of predetermined modifiers for change in the rate of growth, stability within long-term trend, and cyclicality. Adjusted scores for earnings and dividends are then combined to yield a final ranking. The ranking system makes allowance for the fact that corporate size generally imparts certain advantages from an investment standpoint. Conversely, minimum size limits (in sales volume) are set for the various rankings. However, the system provides for making exceptions where the score reflects an outstanding earnings and dividend record. Table 1 shows the letter classifications and brief descriptions of Quality Rankings.
TABLE 1: QUALITY RANKINGS CLASSIFICATION
LETTER DESCRIPTION

A+ A AB+ B BC D LIQ

Highest High Above Average Average Below Average Lower Lowest In Reorganization Liquidation

The ranking system grants some exceptions to the pure quantitative ranking. Thus, if a company has not paid any dividend over the past 10 years, it is very unlikely that it will rank higher than A-. In addition, companies may receive a bonus score based on their sales volume. If a company omits a dividend on preferred stock, it will receive a rank of no better than C that year. If a company pays a dividend on the common stock, it is highly unlikely that the rank will be below B-, even if it has incurred losses. In addition, if a company files for bankruptcy, the models rank is automatically changed to D.

3 Based on the description provided in the Standard & Poors Stock Guide.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

III. Risk and Return Analysis of Quality Rankings Portfolios

In this section we present an analysis of the risk-return performance of different Quality Rankings portfolios. Our analysis provides significant insight into the value of using the rankings in a portfolio management context.

3.1 Methodology4
Our sample includes all common stocks that are listed on NYSE/AMEX/NASDAQ that have Quality Rankings data available in the S&P Compustat annual files. Our sample period begins in December 1985 and ends in December 2004, and extends previous studies.5 Section 6 provides a detailed description of sample size, number of companies, and sector composition of each of the Quality Rankings portfolios. We construct seven portfolios based on Quality Rankings, ranging from A+ to D. We also construct two additional portfolios, the All-A, comprised of stocks with A+, A, or A- rankings, and the All-B, C & D, comprised of stocks with B+, B, B-, C & D rankings. We exclude stocks with prices lower than $1 to avoid the influence of extreme returns on portfolio performance. We compute portfolio returns on both equal-weighted and market-weighted bases and rebalance the portfolios monthly. When S&P Compustat stops reporting monthly data on a stock, we rebalance the market capitalization invested in the stock among the remaining stocks in the Quality Rankings portfolio. The market-weighted portfolios methodology conforms to the academic practice, but we also present equalweighted returns for comparison. The Market-weighted approach of calculating portfolio returns may be more realistic, as portfolio managers generally hold stocks in proportion to their market capitalizations.6 In addition, market weighting alleviates the potential bias that a few small, illiquid stocks with large returns have on portfolio returns.

4 In the February 2003 report we rebalanced the portfolios only once a year and start calculating returns in April 1986. In this report

we rebalance the portfolios on a monthly basis and we calculate returns starting in January 1985. We believe monthly rebalance is more appropriate, as it captures the monthly quality ranking drift. For example, 10% of the S&P 500 ranked companies changed quality ranking between December 2003 and December 2004. 5 Haugen (1979) analyzes risk characteristics of quality rankings for the period 1956-1971; Muller, Fielitz and Greene (1987) study the risk and return characteristics of quality rankings for the period 1970-1984. 6 A number of studies over the last decade provide evidence that institutions tilt portfolios towards larger-capitalization stocks. The studies include Badrinath, Gay and Kale (1989), Del Guercio (1995), and Gompers and Metrick (2001).

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

III. Risk and Return Analysis of Quality Rankings Portfolios

3.2 Risk and Return Analysis7


Table 2 and Figure 1 show that high-quality portfolios have the best overall performance on both return and risk-adjusted bases. The risk-adjusted returns, as measured by the ratio of return to standard deviation or by realized returns in excess of returns on a similar market beta portfolio, are higher for the high-quality portfolios. The A+ Quality Rankings portfolio outperformed the S&P 500 by 110 basis points annually over the 19-year sample period. The portfolio of All-A ranked stocks outperformed the S&P 500 and the portfolio of All-B, C & D ranked stocks by 70 basis points and 100 basis points, respectively. On a risk-adjusted basis, the performance of the all-A portfolio compares even more favorably, as it has lower risk than the S&P 500 and the allB, C & D portfolio. Over the period of analysis, the annualized standard deviation of the all-A portfolio is 14.1%, compared to 15.6% for the S&P 500 and 17.6% for the all-B, C & D portfolio. The market beta of the allA portfolio is lower than 1, at 0.87, whereas the market beta of all-B, C & D portfolio is higher than 1, at 1.08. As a result of higher return and lower risk, the all-A portfolio outperformed the all-B, C & D portfolio by almost 300 basis points annually on a risk-adjusted basis.

7 This and the following sections focus on the market-weighted portfolio results.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

III. Risk and Return Analysis of Quality Rankings Portfolios

FIGURE 1: VALUE OF $10,000 INVESTED IN ALL-A AND ALL-B, C & D PORTFOLIOS MARKET-WEIGHTED RETURNS

$120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 A+, A & AB+, B, B-, C & D S&P 500 $101,976 $90,785 $86,375

TABLE 2: MARKET-WEIGHTED ANNUAL RETURNS FOR QUALITY RANKINGS PORTFOLIOS


YEAR A+ A AB+ B BC&D ALL-A ALL B, C & D S&P 500

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 $10,000 Invested Compound Return Standard Deviation Return/Risk Beta Alpha Skewness

16.9% 3.5% 15.4% 26.2% 6.3% 49.8% 1.9% -2.2% 3.5% 42.6% 23.3% 37.9% 32.9% 16.6% 4.9% -9.0% -20.3% 19.5% 9.1% 108,158 13.4% 15.8% 0.85 0.92 2.01% -0.42

22.7% 3.0% 16.5% 33.3% 2.1% 25.6% 7.2% 2.1% 3.5% 34.0% 22.4% 41.9% 17.2% 0.3% 1.9% -4.0% -19.6% 35.3% 3.0% 85,528 12.0% 14.6% 0.82 0.87 1.25% -0.63

19.5% 1.9% 18.9% 38.0% -4.5% 23.6% 8.4% 12.5% -0.3% 35.5% 22.0% 37.4% 21.6% 14.5% -0.5% -1.7% -8.4% 24.5% 15.6% 116,818 13.8% 13.8% 1.00 0.81 3.51% -0.74

19.1% 1.3% 16.5% 22.5% -13.6% 36.6% 10.1% 11.2% -1.6% 34.6% 23.6% 29.4% 27.5% 28.7% -5.0% -15.9% -17.9% 29.5% 11.6% 81,944 11.7% 16.8% 0.70 1.03 -0.74% -1.05

14.7% 9.6% 20.4% 25.1% -14.1% 25.2% 17.4% 27.6% -0.3% 37.6% 25.2% 25.8% 23.6% 33.8% -7.0% -11.9% -26.0% 34.7% 17.3% 104,494 13.1% 17.9% 0.73 1.08 0.19% -1.00

3.3% 10.4% 17.5% 23.4% -15.6% 22.0% 17.7% 27.1% 0.1% 32.4% 23.0% 24.3% 4.8% 27.1% -16.3% -3.3% -23.5% 40.6% 16.2% 69,496 10.7% 19.7% 0.55 1.11 -2.09% -1.22

-8.5% 7.3% 29.3% 30.5% -27.6% 36.2% 16.1% 25.1% -3.9% 29.9% 0.0% 13.1% 54.7% 102.0% -22.8% -28.1% -44.2% 58.8% 4.6% 53,876 9.3% 29.3% 0.32 1.37 -4.43% -0.16

19.6% 2.9% 16.8% 32.5% 0.8% 32.6% 5.6% 3.7% 2.3% 37.9% 22.8% 39.1% 24.6% 10.6% 2.2% -5.3% -16.7% 24.6% 9.5% 101,976 13.0% 14.1% 0.93 0.87 2.09% -0.67

14.2% 5.5% 18.9% 24.1% -14.5% 30.1% 13.9% 20.4% -0.9% 34.8% 23.4% 26.9% 23.4% 32.5% -8.5% -13.4% -23.2% 35.2% 13.5% 86,375 12.0% 17.6% 0.68 1.08 -0.88% -1.11

18.7% 5.2% 16.6% 31.6% -3.1% 30.4% 7.6% 10.1% 1.3% 37.5% 22.9% 33.4% 28.6% 21.0% -9.1% -11.9% -22.1% 28.7% 10.9% 90,785 12.3% 15.6% 0.79

-0.84

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

III. Risk and Return Analysis of Quality Rankings Portfolios

FIGURE 2: VALUE OF $10,000 INVESTED IN ALL-A AND ALL-B, C & D PORTFOLIOS EQUAL -WEIGHTED RETURNS

$180,000 $160,000 $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 A+, A & AB+, B, B-, C & D Benchmark $155,234 $147,518 $138,599

TABLE 3: EQUAL-WEIGHTED ANNUAL RETURNS FOR QUALITY RANKINGS PORTFOLIOS


YEAR A+ A AB+ B BC&D ALL-A ALL B, C & D

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 $10,000 Invested Compound Return Standard Deviation Return/Risk Skewness

20.8% 1.2% 19.6% 24.2% -6.9% 44.1% 12.2% 2.1% 1.8% 34.0% 24.0% 42.8% 20.7% -1.9% 21.2% 7.0% -5.0% 29.2% 14.6% 145,217 15.1% 14.5% 1.04 -0.74

18.1% -0.8% 20.1% 23.8% -10.2% 39.1% 17.3% 5.8% -1.6% 27.5% 21.2% 44.7% 9.7% -7.9% 16.3% 17.7% 1.6% 32.0% 19.6% 131,684 14.5% 13.3% 1.10 -1.00

19.4% -0.2% 25.6% 26.8% -7.0% 39.7% 19.9% 12.2% -1.9% 29.9% 21.2% 42.0% 8.3% -1.8% 17.4% 17.3% 3.3% 34.5% 19.6% 177,014 16.3% 12.8% 1.27 -1.30

11.9% -2.0% 27.1% 15.8% -14.2% 41.0% 18.1% 16.3% -0.5% 28.0% 19.9% 35.7% 3.5% 3.7% 12.1% 23.0% -0.8% 39.2% 19.8% 136,075 14.7% 14.3% 1.03 -1.60

9.5% -4.3% 32.5% 16.7% -19.4% 41.9% 21.5% 21.1% 1.9% 33.6% 25.1% 29.9% 0.7% 14.1% 11.4% 24.4% -4.0% 48.8% 24.5% 170,591 16.1% 16.4% 0.98 -1.54

8.0% -6.6% 28.3% 9.5% -23.9% 42.9% 31.1% 23.1% 2.8% 29.9% 21.7% 24.9% -5.3% 25.3% 1.7% 26.5% -7.3% 66.2% 28.4% 152,646 15.4% 18.7% 0.82 -1.15

-0.1% -10.0% 17.4% 5.1% -32.9% 37.1% 28.6% 30.8% -2.9% 35.8% 11.0% 8.8% -11.7% 59.8% -10.5% 11.8% -23.4% 100.5% 25.4% 74,433 11.1% 25.7% 0.43 -0.29

19.3% -0.1% 22.5% 25.2% -8.1% 40.4% 17.4% 8.0% -1.1% 29.8% 21.7% 43.2% 10.9% -3.9% 17.6% 15.7% 1.4% 32.8% 18.9% 155,234 15.5% 13.1% 1.18 -1.12

7.9% -5.6% 26.6% 11.9% -22.2% 40.8% 24.9% 22.9% 0.7% 31.7% 20.1% 25.3% -3.2% 24.1% 4.6% 21.7% -9.5% 65.3% 25.0% 138,599 14.8% 18.0% 0.82 -1.22

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

III. Risk and Return Analysis of Quality Rankings Portfolios

3.3 Downside Risk Analysis


As an alternative view of the sensitivity of our results to different phases of the market, we analyze the performance of Quality Rankings Portfolios in up and down markets. This analysis reveals some interesting results on downside protection that high-quality portfolios provide. Table 2 shows that S&P 500 performance was negative in 4 of the 19 years in our sample period. In each of these years, the all-A portfolio outperformed the S&P 500. However, the all-B, C & D portfolio underperformed the S&P 500 in 3 years out of 4. S&P 500 performance was positive in 15 of the 19 years in our sample period. In these up years, the all-A portfolio outperformed the S&P 500 and the all-B, C & D portfolio in 7 of the 15 years. It is clear that historically low-quality stocks have frequently outperformed high-quality stocks in up markets. As may be surmised from the relative returns of the All-A portfolio and as we will further show below, much of the value and most of the historical alpha of the All-A portfolio has been generated in down markets. This is not surprising as the Quality Rankings are a measure of the persistence and stability of earnings and dividends; i.e., a measure of fundamental risk. A high rank ought therefore to correspond to low fundamental risk. We analyze monthly returns data to further characterize the performance of Quality Rankings portfolios in different market cycles. Figure 3 shows the sensitivity, as measured by market beta based on monthly returns, of Quality Rankings Portfolios in up and down markets. Figure 3 shows that the A+ portfolio is the only Quality Rankings portfolio with a systematic risk (beta) greater than 1.0 in up markets and less than 1.0 in down markets.
FIGURE 3: MARKET BETAS OF QUALITY PORTFOLIOS IN UP AND DOWN MARKETS

2.0 Up Markets Down Markets

1.0

0.0 A+ A AB+ B BC&D All-A All-B, C & D

10

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

III. Risk and Return Analysis of Quality Rankings Portfolios

The portfolio of A+ rated stocks is also the portfolio with the highest systematic risk among the Quality Rankings portfolios in up markets. Higher systematic risk in up markets is positive as it implies that the A+ portfolio provides full or higher participation in the up movements. Equally important, in down markets, the A+ portfolio has a low beta. This implies that in down markets, the A+ portfolio does not go down as much as the market does. This switching beta characteristic of A+ Quality Rankings portfolios is highly desirable from a risk perspective. Indeed, portfolio managers often attempt to reduce portfolio volatility in down markets and increase it in up markets. A market-weighted portfolio of A+ stocks delivers this desired changing exposure to the market without demanding a forecast of future returns. This asymmetric behavior of high-quality stocks during up and down markets is in sharp contrast to the behavior of low-quality stocks. In declining markets, low-quality stocks decline more than the market, and in rising markets, they rise less. Figure 4 shows that when the market declines, low-quality portfolios perform significantly worse than highquality portfolios. Thus, when monthly losses on the S&P 500 Index are larger than 8%, the S&P 500 index drops an average of 11.2% and the all-B, C & D portfolio falls on average of 12.5%, while the decline of the all-A portfolio is less at an average of 9.4%.
FIGURE 4: AVERAGE MONTHLY RETURNS IN UP AND DOWN MARKETS

12% 7% 2% -3% -8% -13% -18% All-B, C & D S&P 500 All-A <-8% -8% to -4% -4% to 0% 0 to 4% +4% to +8% >8%

S&P 500 Returns

The risk-return analysis of Quality Rankings portfolios shows that high-quality portfolios exhibit a favorable risk-return profile for long-term investors, as they provide above-market absolute and risk-adjusted returns over the entire period and sub-periods under study. In addition, high-quality portfolios mitigate downside risk. High-quality portfolios, over time, achieve superior returns by losing less in down markets and, in the case of the A+ portfolio, by gaining more in up markets.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

11

IV. Fundamental Analysis of Quality Rankings Portfolios

4.0 Fundamental Analysis of Quality Rankings Portfolios


The analysis of the risk-return profile of Quality Rankings portfolios in Section 3 showed that high-quality portfolios earned higher risk-adjusted returns over the period under study. In addition, high-quality portfolios mitigate downside risk. Section 4 analyzes the sensitivity of Quality Rankings portfolios to the phases of credit and corporate earnings cycles. The results show that high-quality portfolios tend to provide higher returns than both low-quality portfolios and the market index during periods of increasing credit risk and decelerating corporate earnings growth. This is probably because high-quality companies deliver stable earnings growth, whereas low-quality companies deliver unstable earnings growth. Earnings of low-quality companies plummet when overall corporate earnings growth declines. The analysis in Section 4 sheds further light on relative performance of high-quality and low-quality portfolios, especially periods when low-quality portfolios outperform, as they periodically do. Sections 4.1 and 4.2 analyze fundamental characteristics that enable high-quality companies to deliver stable growth in earnings and dividends. It then provides details on the stability of earnings and dividends for the Quality Rankings Portfolios. During the sample period, despite carrying lower financial leverage, highquality companies provided high and stable profitability. Section 4.3 examines the consequences of stable profitability growth and low leverage in detail. In particular, we examine the sensitivities of the growth in earnings for Quality Rankings portfolios over credit and aggregate profit cycles.

4.1 Size, Leverage, and Profitability


Table 4 presents statistics on the size, leverage, and profitability of different Quality Rankings portfolios for four different periods. High-quality portfolios, on average, contain larger firms in terms of sales, total assets and total capital. In particular, A+ companies have become progressively larger than those in the other portfolios. In fact, in 2004, average sales for the A+ companies were more than 4.5 times the average sales for the A companies. The long-term debt to total assets ratio shows that low-quality companies tend to be more leveraged than high-quality companies. Despite lower leverage, return on equity for high-quality companies is well above that of low-quality companies.
TABLE 4.: SIZE, LEVERAGE AND PROFITABILITY OF QUALITY RANKINGS PORTFOLIOS AT DIFFERENT POINTS IN TIME
QUALITY RANKING 1985 SALES ($ MILLIONS) 1993 2001 2004 LONG-TERM DEBT/TOTAL ASSETS6 1985 1993 2001 2004 1985 RETURN ON EQUITY 1993 2001 2004

A+ A AB+ B BC

3,837 2,659 1,910 840 969 364 285

6,529 2,877 2,995 1,867 1,508 1,057 406

13,434 5,829 5,782 3.399 3,196 897 256

19,270 4,095 4,975 3,811 3,687 1,264 568

14.3% 14.4% 19.8% 17.5% 12.3% 21.1% 30.8%

14.6% 14.7% 19.1% 18.2% 18.7% 18.1% 25.5%

16.3% 23.4% 20.2% 24.1% 28.4% 25.4% 34.5%

15.9% 17.8% 17.4% 19.7% 29.0% 25.2% 31.7%

16.0% 12.8% 11.0% 8.3% 5.8% 5.9% -24.0%

20.5% 20.8% 12.8% 14.7% 12.1% 15.0% 11.7% 10.2% 6.5% 2.1% 9.9% -2.9% -4.5% -145.0%

18.3% 17.1% 16.3% 15.2% 11.7% 6.2% -5.1%

* Excludes Financials and General Electric Co. due to its large financial business

12

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

IV. Fundamental Analysis of Quality Rankings Portfolios

4.2 Growth and Profitability Analysis


Table 5 and Figure 5 provide details for the entire sample period on various profitability metrics. Table 5 provides summary statistics for gross and net margin, return on equity, and five-year compound annualized growth rate of earnings and dividend. Figure 4 graphically depicts annual values for net profit margin, return on equity, and five-year compound annualized growth rate of earnings and dividends. High-quality companies have higher and more stable gross and net margins. Companies with A+ Quality Rankings have an average gross margin of 37.7% and average net margin of 7.9%. Moreover, high-quality companies exhibit remarkable stability in their gross and net margin levels. The standard deviation of gross and net margins is 1.5% and 0.9%, respectively, for companies with A+ Quality Rankings. In contrast, lowerquality companies have lower and unstable margins. Net margins for the companies with B- Quality Rankings are 2.0%, with a standard deviation of 2.2%. Our analysis, available upon request, shows that the high-quality companies also deliver steadier sales growth than low-quality companies. Steadier sales growth and high and stable profit margins result in higher return on equity for high-quality companies. In addition to the low standard deviation of return on equity, the fundamental risk of return on equity is lower for high-quality companies, as they carry lower leverage on average.
TABLE 5: MEAN VALUES AND VOLATILITY OF PROFITABILITY METRICS FOR THE PERIOD 1985-2004
S&P QUALITY RANKING GROSS MARGIN AVERAGE ST. DEV. NET MARGIN AVERAGE ST. DEV. RETURN ON EQUITY AVERAGE ST. DEV. 5 YR. CAGR OF EARNINGS AVERAGE ST. DEV. 5 YR. CAGR OF DIVIDENDS PER SHARE AVERAGE ST. DEV.

A+ A AB+ B BC

37.7% 38.0% 34.2% 29.5% 26.3% 24.9% 26.4%

1.5% 5.3% 3.1% 3.1% 3.5% 2.8% 3.9%

7.9% 7.5% 7.0% 5.1% 3.9% 2.0% -7.5%

0.9% 1.7% 1.7% 1.5% 1.5% 2.2% 13.5%

20.1% 15.2% 14.0% 12.1% 9.6% 5.9% -27.0%

2.1% 2.4% 2.2% 2.6% 3.6% 5.5% 40.5%

12.1% 7.5% 5.8% 5.6% 4.5% NM NM

2.0% 3.8% 5.7% 6.5% 14.1% NM NM

13.3% 10.2% 6.9% 6.1% 2.4% 1.5% -14.6%

13.3% 10.2% 6.9% 6.1% 2.4% 1.5% -14.6%

These higher and more stable levels of profitability bring about greater and more stable earnings and dividend growth for the higher-quality companies. Figure 5 shows that low-quality companies display a lower growth rate in dividends and a higher variability of dividends. We also looked at the dividend coverage, the ratio between income before extraordinary items and dividend paid out, by Quality Ranking. The dividend coverage is a measure of the safety of the dividend. It gives the investor an idea of how likely it is that the company will be able to generate enough profits to keep paying the dividend. High-quality stocks covered their dividends quite comfortably over 1985-2004. Higher growth rate and stability of dividends indicates that the quality of future dividends is higher for high-quality companies.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

13

IV. Fundamental Analysis of Quality Rankings Portfolios

The dividend coverage trend mimics earnings growth for both low-quality and high-quality companies. As we noted earlier in this section, low-quality companies tend to be more leveraged. The next section examines whether the high-quality companies ability to grow earnings steadily despite a low leverage allows them to weather the corporate earnings and credit cycles better. Our analysis shows that for low-quality companies, during periods of earnings decelerations, the interest expense burden becomes a large portion of earnings, their cash flows contract, and dividend payments come under pressure. However, high-quality companies earnings growth has a low correlation with overall corporate earnings and, therefore, their earnings and dividends are more insulated from profit recessions.
FIGURE 5: GROWTH AND PROFITABILITY METRICS OVER TIME NET PROFIT MARGIN 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 85 87 89 91 93 95 97 99 01 RETURN ON EQUITY 25% 20% 15% 10% 5% 03 04 0% 85 87 89 91 93 95 97 99 01 03 04 A+ B+ S&P 500 B

A+ B+ S&P 500 B

5-YEAR CAGR OF EARNINGS 40% 30% 20% 10% 0% -10% -20% -30% -40% 85 87 89 91 93 95 97

5-YEAR CAGR OF DIVIDENDS A+ B+ 32% 22% 12% S&P 500 2% B -8% -18% 99 01 03 04 85 87 89 91 93 95 97 99 01 03 04 B A+ B+ S&P 500

4.3 Performance of Quality Rankings Portfolios in Earnings and Credit Cycles


The analysis of risk and return of Quality Rankings portfolios shows that high-quality companies outperform low-quality companies when S&P 500 return is negative. The analysis of fundamental characteristics shows that high-quality companies deliver high and stable return on equity despite their low leverage. This section analyzes the return, profitability, and creditworthiness of Quality Rankings portfolios in detail and in relation to each other.

14

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

IV. Fundamental Analysis of Quality Rankings Portfolios

A study of the relationship of Quality Rankings portfolios to the corporate earnings and credit cycles sheds some additional light on the drivers of relative performance of high- and low-quality stocks. In Figure 6 we graph trailing four quarters earnings growth for the overall S&P 500 on the left vertical axis. An increase in the height of the bars means that corporate earnings growth is accelerating. On the right vertical axis we reported the price index ratio between All-A and All-B, C & D stocks. When the line rises, it means that AllA stocks are outperforming the All-B, C & D stocks. The most important piece of information we take from the chart is that the highest-quality portfolio returns appear to be negatively correlated with the overall profit cycle. The reverse is true for low-quality portfolio returns.8
FIGURE 6: CORPORATE EARNINGS CYCLE AND PERFORMANCE OF QUALITY RANKINGS PORTFOLIOS

EPS Growth S&P 500 Quarterly Trailing 12 Months GAAP EPS Growth 80% Relative Performance 60% 40% 20%

1.6 1.4 1.2 1.0 0.8

0% -20% -40% -60% 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

0.6 0.4 0.2 0.0

This is not surprising in light of our fundamental analysis findings that high-quality stocks tend to generate stable earnings growth over time and are less susceptible to fluctuations in general economic activity (Figure 5). Our analysis also shows that higher-quality companies earnings growth has a low correlation to overall corporate earnings growth as represented by the S&P 500. Conversely, lower-quality companies earnings growth is highly correlated to the overall market. Over the sample period, A+ companies annual earnings growth has a correlation of about zero with earnings growth of the S&P 500; annual earnings growth of B+, B, B- and C companies have a high and positive correlation with earnings growth of the S&P 500. Our analysis also shows that there is positive correlation between the credit downgrade/upgrade ratio and the performance of high-quality stocks in relation to the performance of low-quality stocks. High-quality stocks outperform in deteriorating credit cycles and low-quality stocks outperform in ebullient phases of credit cycles.

8 2004 proved to be an exception in the record of the link between the rate of earnings growth and the relative performance of high

vs. low quality stocks. In fact, despite earnings deceleration, high quality stocks underperformed low quality stocks.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

Relative Performance of All-A Vs. All-B Stocks

100%

1.8

15

IV. Fundamental Analysis of Quality Rankings Portfolios

The explanation for the difference in performances of low- and high-quality stocks through the earnings and credit cycles requires a further examination of credit markets impact on companies operations. Changing credit market conditions have very different effects on low- and high-quality companies business and financial risks, and profitability. Our analysis in Section 4.1 shows that low-quality companies are generally more leveraged as indicated by the debt-to-total assets ratio. Although greater leverage allows low-quality companies to be more profitable during times of low interest rates and earnings growth, it also makes their profits more vulnerable to tightening monetary policy and corporate earnings deceleration. The high leverage and vulnerability of low-quality companies to credit and interest rate cycles are also reflected in their credit ratings. Figure 7 shows the percent of companies with a Standard & Poors Credit Rating of A- or better on senior debt.9 Generally, as one would expect, companies with high quality of earnings tend to also have high credit quality. Thus, low fundamental risk is consistent with high credit rating. However, we notice that even among high-quality companies there has been a decline in credit quality. Changes in financial policy and in the business environment have been identified as the most significant drivers of the declining credit quality of the U.S. corporations.10
FIGURE 7: PERCENTAGE OF COMPANIES WITH S&P CREDIT RATING OF A- OR BETTER

70% 60% 50% 40% 30% 20% 10% 0% 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 A AA+ S&P 500

All-B, C & D 02 03 04 05

9 The Standard & Poors Credit Rating represents the opinion of an issuers overall creditworthiness, apart from its ability to repay

individual obligations. This opinion focuses on the obligors capacity and willingness to meet its long-term financial commitments as they come due. A credit rating of A- to AAA indicates strong capacity to meet financial commitments. 10 See the report The Decline and Fall of the AAA Rated Company, CreditWeek, March 16 2005.

16

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

IV. Fundamental Analysis of Quality Rankings Portfolios

To analyze the interaction between creditworthiness and profit cycles, Figure 8 graphs the ratio between interest expense and the sum of after-tax earnings and interest expense for high- and low-quality ranking portfolios11. A rising line indicates that interest cost is becoming a higher percentage of after-tax earnings. The sum of interest expense and after-tax earnings is effectively the total income available to providers of capital. Thus, this ratio can also be interpreted as the percent of total income going to satisfy the debtholders. For bondholders, the interest coverage ratio is a sort of safety gauge, since it provides a sense of how far a companys earnings can fall before it will start defaulting on its bond payments. We notice that as we move from high- to low-quality companies, the level and volatility of the ratio increase. Changes in interest rates imply a larger impact on the interest expense burden of low-quality companies, which in turn implies a larger negative impact on their future earnings and cash flows. Low-quality companies tend to have more limited access to capital markets and tend to use more bank loans. Low-quality firms generally do not have the same ability to raise external funds and, as a consequence, are more adversely affected by lower liquidity and higher short-term interest rates. Thus, during periods of increasing interest rates, low-quality companies balance sheets weaken as net worth declines and higher interest costs reduce operating cash flows.
FIGURE 8: IMPACT OF INTEREST RATE ON INTEREST COVERAGE RATIO OF HIGH- AND LOW-QUALITY COMPANIES

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% High Quality (A+) (left-axis) 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 FedFund Rate (right axis) Low Quality (B) (left axis)

10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0%

The effects of the corporate cash-flow squeeze on companies operations depend largely on companies ability to smooth the drop in cash flows by borrowing. High-quality firms are more likely to have far greater access to commercial paper markets and other sources of low-cost short-term credit, and to respond to an unanticipated decline in cash flows by increasing their short-term borrowing. Conversely, because low-quality firms do not have the same accessibility to short-term credit markets, they respond to the cash-flow squeeze principally by selling off inventories through price discounting and by slashing production.
11 We actually chose to plot the inverse of the interest coverage ratio for clarity of representation. The interest coverage ratio meas-

ures the immediate effect of increasing interest costs on profitability. October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

17

IV. Fundamental Analysis of Quality Rankings Portfolios


This conjecture is confirmed by our analysis showing that high-quality companies have progressively increased the short-term debt portion of their total debt. For example, recently, A+ companies had, on average, a 58% short-term debt to total debt ratio, versus 27% for B companies. This is likely due to high-quality companies recourse to the commercial paper market. Commercial paper is an unsecured form of short-term debt used primarily by large, well-established corporations for short-term borrowing needs. It is attractive because it usually carries an interest rate lower than those on a longer-term loan or an equivalent bank borrowing. Commercial paper issuance is restricted to companies with strong balance sheets and high cash flows. In Figure 8 we also graphed the Fed Funds rate. It is evident from the graph that the trend in interest coverage ratio for low-quality companies is dramatically different from that in high-quality companies and that it follows the interest rate cycle. High-quality companies coverage ratio seems to be immune to interest rate movements. In effect, A+ companies have been steadily improving their coverage ratios between 1985 and 2004. For low-quality companies the story is radically different, as profits and cash flows decline following an increase in interest rates. In fact, higher interest rates directly decrease corporate profits. After an increase in interest rates, low-quality companies corporate profits tend to fall more quickly than costs, which tend to be quasi-fixed in nature. Both of these factors lead to a significant corporate cash squeeze during a period of monetary tightening. To summarize, since low-quality firms have more volatile businesses and more limited access to credit markets, they tend to be affected more by credit constraints. In particular, it is precisely during recessions that credit constraints are more binding for low-quality companies. As interest rates rise and credit markets tighten, low-quality companies balance sheets deteriorate and their cash flows decrease because of the higher interest expense burden. Additionally, as higher interest rates decrease the overall demand in the economy, low-quality companies revenues, profits and cash flows diminish further. Furthermore, since tighter liquidity reduces the amount of funds that banks can lend, low-quality companies, which are heavily dependent on bank loans, are impacted by tighter credit. This higher exposure of low-quality companies earnings and cash flows to tighter credit markets increases their business and financial risk and their probability of credit default. This translates into a higher risk during recessions for low-quality companies. This asymmetric behavior of high- and low-quality companies through the profit and credit cycles helps to explain why, in a period of worsening credit conditions characterized by higher short-term interest rates and higher default premia, low-quality companies stocks become riskier and investors move into larger, bettercollateralized, higher-quality companies.

18

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

V. Quality of Earnings

5.0 Quality of Earnings


While the problem of earnings management is not new, it has swelled in a market that is unforgiving of companies that miss their estimates. I believe that almost everyone in the financial community shares responsibility for fostering a climate in which earnings management is on the rise and the quality of financial reporting is on the decline. Arthur Levitt, speech on September 28, 1998
The term quality of earnings has been used with different interpretations in a variety of contexts. For example, in the bull market of the late 1990s, investors rewarded higher valuations to the companies that they thought provided high-quality earnings companies that systematically, quarter after quarter, met or beat estimates. However, consistent and positive earnings surprises and earnings growth over a short time period may reflect aggressive accounting, earnings management and poor quality of earnings. As earnings growth is an important factor in the determination of Quality Rankings, an examination of whether there is any correspondence between Quality Rankings and quality of earnings is necessary. Our analysis confirms the prudence of Quality Rankings System. The Quality Rankings reflect earnings and dividend growth over a long time period over which it is difficult to sustain accounting manipulation. Our results show that companies with higher Quality Rankings have higher quality of earnings. Academics, practitioners, and regulators have used the term quality of earnings with varied meanings over time as earnings of a corporation can be manipulated in several ways. We look at quality of earnings from three different perspectives. First, we analyze the difference between Standard & Poors Core Earnings and reported earnings. (Standard & Poors Core Earnings methodology, which standardizes the definition of operating earnings, has received wide recognition). Second, we analyze the magnitude of special and extraordinary items in relation to the reported earnings, a simple measure frequently analyzed in academic studies (for example, Ball and Shivakumar (2001)). Finally, we show that the cross-sectional variation in analyst estimates is lower for high-quality firms, suggesting that the reporting practices of high-quality firms allow analysts to consistently analyze the underlying businesses.

5.1 Quality Rankings and Standard & Poors Core Earnings


Standard & Poors Core Earnings refers to the after-tax earnings generated from a corporations principal business. Standard & Poors Core Earnings begins with as-reported earnings and then makes a series of adjustments. Standard & Poors Core Earnings back out the following items from as-reported earnings as defined by GAAP: extraordinary items, cumulative effects of accounting changes, discontinued operations, goodwill impairment charges, gains/losses from asset sales, pension gains, litigation or insurance settlements and proceeds, and reversal of prior- year provisions. Items included in the calculation of Standard & Poors Core Earnings are employee stock option grant expense, restructuring charges from ongoing opera-

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

19

V. Quality of Earnings

tions, asset writedowns, pension costs, purchased R&D expenses, merger- and acquisition-related expenses, and unrealized gains/losses from hedging activities.12 Figure 9 shows, for the most recent four years, the difference between Standard & Poors Core Earnings and as-reported earnings in aggregate for each Quality Ranking portfolio. To examine the pattern of difference between Standard & Poors Core Earnings and as-reported earnings without influential observations, we graph the median difference for the cross-section of companies in each Quality Ranking portfolio. Our results show a striking positive relationship between quality of earnings as defined by the Standard & Poors Core Earnings methodology and the Quality Rankings. In any single year low-quality ranking companies reported a larger difference between Standard & Poors Core Earnings and as-reported earnings than high-quality companies. This difference tends to be larger during periods of economic recession and deceleration of corporate earnings growth due to the increasing occurrence of asset writedowns and restructuring charges.
FIGURE 9. MEDIAN PERCENTAGE DIFFERENCE BETWEEN CORE EARNINGS AND AS-REPORTED EARNINGS

40% 35% 30% 25% 20% 15% 10% 5% 0% 2001 2002 2003 2004 A+ A- B+ A A+ A B B BB+ AA+ A A-B+ B A+ A A-B+ BB BC BC C C

5.3 Quality Rankings and Special and Extraordinary Items


The previous section focused on operating earnings. Several academic studies note that analysts focus on operating earnings and exclude special and extraordinary items when estimating a companys earnings power. However, special and extraordinary items have implications for previously reported and future earnings. If nonrecurring charges are actually prior-year expenses taken too late, or future expenses charged off early, then the practice of ignoring nonrecurring charges and focusing on recurring operating income results in an overestimation of the firms earning power.13 Furthermore, while special items are frequently associated with
12 Blitzer, Friedman, and Silverblatt (2002).

20

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

V. Quality of Earnings

firms experiencing challenges in operating environment, companies management may use both the timing and the magnitude of special items to engage in earnings smoothing. Even extraordinary items that are excluded from the calculation of reported (GAAP) earnings, such as charges related to discontinued operations, may impact sustainability of earnings and affect analysts forecasting ability of corporate earnings per share. Figure 10 reports, for the 1985-2004 period, special and extraordinary items and discontinued operations as a percentage of operating income for the different Quality Rankings portfolios. We note that over the period under study, low-quality companies have reported a higher percentage of special and extraordinary items and discontinued operations.14
FIGURE 10. SPECIAL AND EXTRAORDINARY ITEMS AND DISCONTINUED OPERATIONS AS A PERCENTAGE OF OPERATING INCOME FOR QUALITY RANKINGS PORTFOLIOS A+ 60% Special Items 40% 20% 0% 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 A60% 40% 20% 0% 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 B 60% 40% 20% 0% 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 Extraordinary Items & Discontinued Operations 40% 20% 0% 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 B+ 60% 40% 20% 0% 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 S&P 500 60% 40% 20% 0% 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 A 60%

13 White, Sondhi and Fried (1997), p. 64. 14 Note that graphs have same scale to facilitate comparison among Quality Ranking groups.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

21

V. Quality of Earnings

5.3 Quality Rankings and Dispersion in Analyst Forecasts


The presence of special and extraordinary items complicates the task of forecasting earnings. The accuracy of earnings forecasts is of primary importance to market participants because earnings projections are a central input to investment decisions. In addition, investors demand higher risk premiums for investments in companies with higher uncertainty of future earnings. Figure 11 illustrates the relationship between analysts average long-term projected growth rates of earnings and the uncertainty surrounding those forecasts as measured by the average standard deviation of the estimates as of May 2005. High-quality companies are associated with a lower degree of future earnings uncertainty. Conversely, analysts disagreement on future earnings growth increases as we move from highto low-quality companies. The distance between the hollow diamonds and the solid diamonds is equivalent to the estimated growth rate minus two standard deviations, and represents the downside risk embedded in those estimates.
FIGURE 11: ANALYSTS GROWTH FORECAST CONSENSUS AND DISPERSION AS OF DECEMBER 2004

Long-Term Consensus Growth Estimates

25.0 C & Below B14.0 A+ A 8.5 AB+ B

19.5

3.0

1.0

2.0 3.0 4.0 5.0 6.0 Standard Deviation of Long-Term Consensus Growth Estimates

7.0

To summarize, companies ranked highly by the Quality Rankings System exhibit higher quality of earnings as indicated by the low divergence between their GAAP earnings and Standard & Poors Core Earnings, and by the low ratio of special and extraordinary items to reported earnings. Lower dispersion in analyst estimates also indicates higher quality of earnings for high-quality companies. Earnings quality is of primary importance to investment analysts since earnings are a very important input to valuation models that try to calculate the intrinsic value of a stock.

22

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

VI. Portfolio Characteristics of Recent and Historical Quality Rankings Portfolios


6.1 Quality Rankings Portfolio Characteristics and Composition
Table 6 illustrates the distribution of the Quality Rankings at different points in time. Currently, Standard & Poors ranks over 4,000 U.S. companies.15 The quantitative model that generates the rankings is based on an absolute score, and not on a relative score to the universe. There is no adjustment made to force a certain percentage of companies in each quality bracket; as a result, the rankings are not uniformly distributed. Currently, approximately only 13% of all the ranked stocks have ranks of A- or better; the majority of ranked stocks fall in the lower-quality segment.
TABLE 6: QUALITY RANKINGS: NUMBER AND PERCENT OF TOTAL RANKED STOCKS
1985 NUMBER OF COMPANIES 1990 NUMBER OF COMPANIES 1995 NUMBER PERCENT OF COMPANIES OF TOTAL 2004 NUMBER OF COMPANIES

QUALITY RANKING

PERCENT OF TOTAL

PERCENT OF TOTAL

PERCENT OF TOTAL

A+ A AB+ B BC

173 280 382 623 482 443 334

6.4% 10.3% 14.1% 22.9% 17.7% 16.3% 12.3%

115 205 248 413 483 603 455

4.6% 8.1% 9.8% 16.4% 19.2% 23.9% 18.0%

82 157 205 504 635 771 597

2.8% 5.3% 6.9% 17.1% 21.5% 26.1% 20.2%

73 182 237 518 662 889 1106

2.0% 5.0% 6.5% 14.1% 18.1% 24.2% 30.2%

FIGURE 12: HIGH-TO-LOW QUALITY RATIO OVER TIME

70% 60% 50% 40% 30% 20% 10% 0% 1985 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 2004

15 The present study refers to the Quality Rankings System on U.S. companies that qualify under the 10 years of information required

by the Quality Rankings model. Standard & Poors also ranks stocks internationally.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

23

VI. Portfolio Characteristics of Recent and Historical Quality Rankings Portfolios


A historical analysis of Quality Rankings is more informative about the rankings dynamics than a snapshot at a specific point in time. Since the Quality Rankings are based on earnings growth and stability over a 10-year period, one would expect that the quality distribution and sector makeup change over time in relation to macro- and microeconomic factors. Table 6 and Figure 12 show that over the period under study, the proportion of lower-quality stocks has been increasing and that the high-to-low quality ratio has been steadily declining.16 A plausible explanation for the decline in the number of high-quality companies is that the business environment has become increasingly competitive due to market deregulation and global competition. As a consequence, companies able to achieve long-term stable earnings growth are becoming increasingly scarce. In addition, the percentage of companies paying a dividend has been steadily declining since 1985. Table 7 reports the price per share, market value and trading volume by Quality Rankings portfolios. On average, higher-quality companies have higher market values and higher prices per share. In addition, trading volume is significantly higher for the higher-quality portfolios. Liquidity is a significant factor that institutional money managers evaluate before buying a stock, as they prefer to invest in very liquid issues that can be bought and sold without impacting the market price.
TABLE 7: PRICE, MARKET VALUE AND TURNOVER BY QUALITY RANKINGS
QUALITY RANKS MEDIAN PRICE PER SHARE MEDIAN MARKET VALUE ($ MILLIONS) AVERAGE MONTHLY VOLUME ($ MILLIONS)

A+ A AB+ B BC

42 35 31 28 23 12 3

6,219.3 1,570.8 1,632.6 977.0 713.6 180.4 50.1

1,909 800 697 596 484 272 100

High-quality stocks are ideally employed in portfolio strategies that try to maintain low portfolio turnover. In effect, besides their greater liquidity, average prices per share and market size, high-quality companies rankings are quite stable over time. This is intuitive, as the model is mainly based on stability of earnings and dividends over 10 years. Table 8 is a transitional probabilities matrix for the rankings. It shows the percent of occasions in which a company with a certain rank in the current year maintains the same rank in the next year.

16 The high-to-low quality ratio is the ratio between the total number of A+, A and A- stocks to the total number of B, B-, C and D

stocks. B+ stocks (average rank) are intentionally omitted to highlight the high-low-quality relationship.

24

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

VI. Portfolio Characteristics of Recent and Historical Quality Rankings Portfolios

TABLE 8: TRANSITIONAL PROBABILITIES MATRIX FOR QUALITY RANKINGS


PERCENTAGE BREAKDOWN OF RANKING IN FOLLOWING YEAR NEXT YEARS RANK A+ A AB+ B BC D LAPSED NUMBER OF RANKING17 OBSERVATIONS

A+ A AB+ B BC D

83.73 5.22 0.00 0.00 0.00 0.00 0.00 0.00

12.74 74.25 9.84 0.12 0.00 0.00 0.00 0.00

0.53 15.21 68.23 6.29 0.01 0.00 0.00 0.00

0.12 1.25 16.80 73.43 9.03 0.00 0.00 0.00

0.12 0.10 0.55 13.53 69.50 8.89 0.00 0.00

0.00 0.00 0.02 0.31 13.13 70.27 13.94 0.38

0.00 0.03 0.20 0.30 1.30 12.94 73.78 1.89

0.06 0.03 0.02 0.11 0.18 0.41 1.33 41.21

2.71 3.91 4.34 5.92 6.84 7.49 10.92 56.5

1,696 3,122 4,035 8,080 9,266 10,982 8,943 529

17 Percent of companies whose Quality Rankings lapsed due to merger, bankruptcy, or other event.

Thus, for example, based on past data, the probability that a company ranked A+ in the current year will maintain the same rank in the next year is 84%. We notice that high-quality companies are significantly more likely to maintain their high-quality ranking over time, making their current rankings a significant predictor of their future rankings.

6.2 Quality Rankings Sector Makeup


Figure 13 shows the sector share of higher-quality stocks (A- or better).18 Currently, financials dominate, representing about 31% of higher-quality stocks. An analysis of earnings quality by sector composition over time reveals that high quality is not dominated by one or two sectors. Instead, it oscillates between sectors and industries over time in relation to sectors earning power and stability. In turn, steady growth is affected by several factors, such as competition, market deregulation and government intervention. For example, the deregulation of the electric utility and natural gas industries had a dramatic impact on the earnings quality of the utilities sector. Prior to 1992, highly regulated and vertically integrated utility companies were assured stable earnings growth. Then, beginning with the National Energy Policy Act of 1992, the Federal Energy Regulatory Commission (FERC) started the process of opening up the wholesale operations to a more competitive market environment, which made earnings growth much more volatile and difficult to predict. Contrary to general perception, the technology sector has always represented a small fraction of the high-quality universe. This is due to intense competition and technologys inherent cyclical nature caused by the incessant introduction of new technologies that result in increasingly shorter product life cycles, and volatile profit margins and earnings.

18 High Quality Rankings stocks as a percentage of total for the S&P 500.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

CURRENT YEAR RANK

25

VI. Portfolio Characteristics of Recent and Historical Quality Rankings Portfolios

FIGURE 13: CURRENT BREAKDOWN OF AND TREND IN S&P 1500 SECTOR COMPOSITION OF ALL-A PORTFOLIO 40% Telecoms 1.0% Technology 4.5% Energy Utilities 0.3% Materials 6.6% 4.5% 35% Industrials 15.7% 30% 25% 20% 15% 10% Financials 34.6% Healthcare 5.6% Discretionary Staples 15.7% 11.2% 5% 0% 1994 95 96 97 98 99 00 01 02 03 2004 Financials Technology Utilities

The low percentage of health care companies among the high-quality companies may also be surprising since many investors generally view the health care sector as a defensive one capable of generating revenue and earnings growth in both good and bad times. The reality is that the healthcare sector is made of diverse sub-industries such as medical devices, managed health care, pharmaceuticals, and biotechnology, all driven by different factors. For example, in the 1991-1992 period, the sharp fall in prescription prices diminished drugs companies pricing power, margins and, therefore, earnings growth. By the same token, government regulation that affects reimbursement programs has, in the past, impacted the various segments of the health care sector making their growth patterns more volatile. On the other hand, we notice that a majority of large pharmaceutical firms have consistently been given high Quality Rankings. For example, Johnson & Johnson was consistently ranked A+ or A from 1968 to 2004. Over the 1985-2004 period, as one would expect, the company generated respectable compounded annual growth rates of 14.8% in both dividends and earnings. The financial sector has the greatest concentration of high-quality companies, and its growing dominance of the high-quality universe is explained by industry trends and macroeconomic factors. The performance of this sector has been driven by ongoing consolidation, technology-driven efficiency improvements, diversification into new lines of business, better duration matching of asset and liabilities, and a favorable interest rate environment (versus the late 1970s and early 1980s). The financial sector achieved more stable margins and earnings growth as fee-based revenues increasingly represented a higher percentage of total revenues, and as they reduced their dependence on interest rate-based income. The major lesson we learn from Figure 13 is that quality is not static, but fluctuates across sectors and industries according to numerous business environmental factors. Thus, we should not assume that todays high-quality sectors, industries or companies will be tomorrows.

26

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

VI. Portfolio Characteristics of Recent and Historical Quality Rankings Portfolios


6.3 Quality Ranking, Capitalization, and Growth-Value Split Analysis
Next, we present the distribution of Quality Rankings and their sensitivity to growth and value factors for the three different stock capitalization universes: large-caps (S&P 500), mid-caps (S&P MidCap 400), and smallcaps (S&P SmallCap 600). Figure 14 shows that, as of June 2005, a majority of the high-quality companies are in the S&P 500 universe. Of the 80 A+ companies, 44 are in the S&P 500, 12 are in the S&P MidCap 400, and just 2 are in the S&P SmallCap 600. This does not come as a surprise since the S&P 500 is populated with large companies that have longer operating histories. Conversely, smaller capitalization firms are likely to be relatively newer businesses with shorter operating histories. Thus, small-cap stocks, which are traditionally associated with higher risk premia, also have overall lower-quality rankings.
FIGURE 14. QUALITY RANKINGS DISTRIBUTION BY INDEX

60% Percent of Ranked Stocks in Index 50% 40% 30% 20% 10% 0% A+ A AB+ B BC S&P 500 S&P MidCap 400 S&P SmallCap 600

Table 9 reports the growth-value splits, by price-to-book value, for the three stock universes as of June 2005. We notice that high-quality companies (A+, A and A-) do not fall exclusively in either the value or growth category. Rather, we see a quite balanced split between growth and value for all three stock universes.
TABLE 9: GROWTH-VALUE SPLIT OF HIGH QUALITY (A+, A AND A-) AS OF JUNE 2005
MARKET VALUE ($ MIL) OF UNIVERSE MARKET VALUE OF UNIVERSE AS A % OF TOTAL INDEX MARKET CAP

UNIVERSE

GROWTH %

VALUE %

All-A in S&P 500 All-A in S&P MidCap 400 All-A in S&P SmallCap 600

5,320,557.7 258,001.7 746,63.4

48.2% 23.2% 13.8%

57.5% 50.6% 51.8%

42.5% 49.4% 48.2%

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

27

VI. Portfolio Characteristics of Recent and Historical Quality Rankings Portfolios


Figure 15 reports the percentage of high-quality companies (all-A) classified as growth or value by the S&P 500/Barra Growth and Value Indices.
FIGURE 15: ALL-A COMPANIES CLASSIFIED AS GROWTH OR VALUE AS A PERCENTAGE OF TOTAL

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1985 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 2004 Value-HQ Growth-HQ

We observe that over the period under study, the all-A portfolio has tilted toward value. More recently, the portfolio has been increasing its exposure to the growth universe.

28

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

VI. Portfolio Characteristics of Recent and Historical Quality Rankings Portfolios


6.4 Valuation Multiples Analysis
High-quality stocks in a portfolio provide higher risk-adjusted returns. But the question remains: Does this risk protection come at a cost? In other words, is the high-quality portfolios greater profitability reflected in higher market valuation multiples?
FIGURE 16: PRICE-TO-BOOK AND PRICE-TO-SALES RATIOS FOR QUALITY RANKINGS PORTFOLIOS PRICE-TO-BOOK 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 85 87 89 91 93 95 97 99 01 03 04 RELATIONSHIP BETWEEN PRICE-TO-BOOK AND RETURN ON EQUITY 1985-2004 4.5 4.0 3.5 A 3.0 B+ A2.5 B- B 2.0 1.5 1.0 0.5 0.0 0.0% 5.0% 10.0% 15.0% Return on Equity Price-to-Book Ratio

A+

All-A All-B & C

20.0%

25.0%

PRICE-TO-SALES 3 2.5 2 1.5 1 0.5 0 85 87 89 91 93 95 97 99 01 03 04

All-B & C

In order to answer this question, we examined various valuation multiples. The left-side part of Figure 16 graphs the price-to-book and price-to-sales for the different Quality Rankings portfolios. It is evident that the higher the quality, the higher the market valuation multiples. A valuation matrix that relates market multiples with their fundamental drivers is more informative than simply comparing market multiples across stocks, sectors or industries. On the right side of Figure 13 we plot the price-to-book as a function of return on equity and the price-to-sales as a function of net profit margin for the different Quality Rankings portfolios. There is almost a perfect correlation between profitability and market valuation multiples the higher the quality, the greater the profitability and the higher the market multiples. Higher price-to-book ratios reflect higher returns on equity, and higher price-to-sales ratios reflect higher net profit margins. Thus, the market correctly assigns valuation premia to high-quality stocks in terms of price-to-book as well as price-to-sales ratios. These valuation premia appear to persist over the entire period under study.
October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

Price-to-Sales Ratio

All-A

RELATIONSHIP BETWEEN PRICE-TO-SALES AND NET PROFIT MARGIN 1985-2004 1.8 A+ 1.6 A 1.4 A1.2 B+ 1.0 B0.8 B 0.6 0.4 0.2 0.0 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% Net Profit Margin

29

VI. Portfolio Characteristics of Recent and Historical Quality Rankings Portfolios

FIGURE 17: EARNINGS YIELD FOR A+ AND B QUALITY RANKINGS PORTFOLIOS

12% 10% 8% 6% 4% 2% 0% -2% 1985 86 All-A All-B & C 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 2004

However, we do not find the same clear-cut relationship for the price-to-earnings multiple. Figure 17 graphs the earnings yield, the inverse of the price-to-earnings multiple, for the high quality (A+, A & A-) portfolio and the low-quality (B+,B & B- & C) portfolio.19 As expected, low-quality portfolios have more volatile earnings multiples due to their higher earnings volatility. More importantly, we notice that despite superior long-term earnings growth and earnings stability, the market does not always attribute a valuation premium to highquality companies in terms of earnings multiple. The price-to-earnings for a stable growth firm can be derived from the stable-growth dividend discount model. According to this model, the price-to-earnings ratio is an increasing function of the payout ratio and the growth rate, and a decreasing function of the riskiness of the firm. Therefore, during periods of strong corporate earnings growth and low credit risk, low-quality companies earnings multiples will be higher than those of high-quality companies, as investors are willing to move to riskier investments. However, when corporate earnings growth decelerates and credit risk increases, the high-quality companies will be a more attractive investment since they pay out more dividends and have less business and financial risk. Thus, the earnings yield ratio trend seems to reflect a cyclical component related to overall corporate earnings growth and credit risk. When earnings growth decelerates, investors might be willing to pay a premium for highquality companies for the safety they provide; Section 4 shows that when profits decline and the credit environment tightens, high-quality companies provide safety by providing more stable earnings, higher dividend growth rates, lower financial and business risk, and higher profitability.

19 Since the price-to-earnings ratio is very volatile, for clarity of representation, we chose to plot the earnings yield.

30

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

VII. Conclusion

Standard & Poors Quality Rankings provide a simple yet very useful summary measure of the quality of a companys stock. The Quality Rankings System captures the growth and stability of earnings and dividend record of a company over the most recent 10-year period in a single symbol. The assessment of fundamentals over this long period ensures that the Quality Rankings are not unduly influenced by short-term factors and possible accounting manipulations. Quality Rankings are not designed to be a comprehensive measure of the quality of a companys accounting practices, or a tool to provide investment advice. Analytical products such as Standard & Poors Core Earnings and STARS provide more detailed analysis of a companys accounting practices. Standard & Poors STARS are also designed to offer investment advice. Our analysis shows, however, that despite their brevity and simplicity, Quality Rankings are correlated with several measures of quality of earnings, including Standard & Poors Core Earnings. Our analysis also shows that portfolios of high-quality companies provide higher returns and lower risk. The risk characteristics of high-quality portfolios are attractive, as they provide full participation in up markets and mitigate down movements of the market. We further characterize the factors that contribute to the better performance of high-quality companies when the market is declining. High-quality companies perform better in terms of profitability and portfolio returns, when aggregate earnings are declining and the credit cycle is tightening because of their steadiness of sales growth, level and stability of profitability, size, and lower leverage. High-quality companies are appealing investments because of their better risk-return characteristics, higher liquidity and large size.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

31

References

Badrinath, S., G. Gay, and J. Kale. Patterns of Institutional Investment, Prudence, and the Managerial Safety-Net Hypothesis. Journal of Risk and Insurance 56, 1989, pp.605-629. Ball, R., and L. Shivakumar, Earnings Quality in U.K. Private Firms, University of Chicago and London Business School, October, 2002 Bernanke, B., and M. Gertler. Agency Costs, Collateral, and Business Fluctuations. NBER Working Paper 2015, 1986. Bernstein, R. Style Investing. John Wiley & Sons, 1995. Blitzer, D. M., R. E. Friedman, and H. Silverblatt. Measures of Corporate Earnings. Standard & Poors White Paper, May, 2002. Bos, R. An Overview of Standard & Poors Earnings and Dividend Quality Rank Model. Standard & Poors White Paper, July 2000. Calomiris, C., C. P. Himmelberg, and P. Wachtel. Commercial Paper, Corporate Finance, and The Business Cycle: A Microeconomic Perspective. Carnegie-Rochester Conference Series on Public Policy 42, 1995, pp. 203-250. Chung H. K. Marketing of Stocks by Brokerage Firms: The Role of Financial Analysts. Financial Management, Summer 2000. Cooley, T., and V. Quadrini. Monetary Policy and The Financial Decisions of Firms. Mimeo, University of Rochester, 1997. Del Guercio, D. The Distorting Effects of the Prudent-man Laws on Institutional Equity Investments. Journal of Financial Economics 40, 1995, pp. 31-62. Doyle, J. T., R. J. Lundholm, and M. Soliman. The Predictive Value of Expenses Excluded from Pro Forma Earnings. Working Paper, University of Michigan Business School, 2002. Fernando, C. S., V. Gatchev, and P. A. Spindt. Price versus Quality: The Uncommon Case of Common Stocks. Working Paper, 2003. Gertler, M., and C. S. Lown. The Information in The High Yield Bond Spread For The Business Cycle: Evidence and Some Implications. NBER Working Paper 7549, 2000. Gompers, P., and A. Metrick, Institutional Investors and Equity Prices." The Quarterly Journal of Economics 116(1), February 2001, pp 229-259.

32

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

References

Graham, B., and D. Dodd. Security Analysis. New York: McGraw Hill, 1934. Haugen, R. Do Common Stock Quality Ratings Predict Risk? Financial Analysts Journal 35, March-April 1979, pp. 68-71. Levitt, A., The Numbers Game. Remarks delivered by SEC chairman Arthur Levitt Delivered at the New York University Center for Law and Business, September 28, 1998. http://www.sec.gov/news/speech/speecharchive/1998/spch220.txt. Muller, F., and B. Fielitz. Standard & Poors Quality Ranking Revisited. Journal of Portfolio Management 13, Spring 1987, pp. 64-68. Muller, F., B. Fielitz, and M. Greene. S&P Quality Rankings: Risk and Return. Journal of Portfolio Management 9, Summer 1983, pp.39-42. Muller, F., B. Fielitz, and M. Greene. Portfolio Performance in Relation to Quality, Earnings, Dividends, Firm Size, Leverage, and Return on Equity. Journal of Financial Research 7, Spring 1984, pp.17-26. Opler T., L. Pinkowitz, R. Stulz, and R. Williamson. The Determinants and Implications of Corporate Cash Holdings. NBER Working Paper 6234, 1997. Penman H. S. and Xiao. J. Zhang, " Accounting Conservatism, the Quality of Earnings, and Stock Returns". The Accounting Review, Volume 77, Number 2, 2002. Perez-Quiroz, G., and A. Timmermann. Firm Size and Cyclical Variations in Stocks. Journal of Finance, 55 (3), pp. 1229-62, 2000. Rappaport, A. Creating Shareholder Value. The Free Press, 1986. Ramezani, A., L. Soenen, and M. Jung. Growth, Corporate Profitability, and Value Creation. Financial Analysts Journal, pp. 56-67, November-December 2002. Stevenson, R. The Variability of Common Stock Quality Ratings. Financial Analysts Journal 22, pp. 97-101, November-December 1966. Stewart, B. The Quest For Value. HarperBusiness, 1991. White, G. I., A. C. Sondhi, and D. Fried. The Analysis and Use of Financial Statements. John Wiley & Sons, 1997.

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

33

Disclaimer

This report is published by Standard & Poors, 55 Water Street, New York, NY 10041. Copyright 2003. Second Edition. Standard & Poors (S&P) is a division of The McGraw-Hill Companies, Inc. All rights reserved. Standard & Poors does not undertake to advise of changes in the information in this document. Standard & Poors has used information available on public websites to produce this report. These materials have been prepared solely for informational purposes based upon information generally available to the public from sources believed to be reliable. Standard & Poors makes no representation with respect to the accuracy or completeness of these materials, whose content may change without notice. Standard & Poors disclaims any and all liability relating to these materials, and makes no express or implied representations or warranties concerning the statements made in, or omissions from, these materials. No portion of this publication may be reproduced in any format or by any means including electronically or mechanically, by photocopying, recording or by any information storage or retrieval system, or by any other form or manner whatsoever, without the prior written consent of Standard & Poors. Standard & Poors does not guarantee the accuracy and/or completeness of the Standard & Poors Quality Rankings System, any data included therein, or any data from which it is based, and Standard & Poors shall have no liability for any errors, omissions, or interruptions therein. Standard & Poors makes no warranty, express or implied, as to results to be obtained from the use of the Standard & Poors Quality Rankings System. Standard & Poors makes no express or implied warranties, and expressly disclaims all warranties of merchantability or fitness for a particular purpose or use with respect to the Standard & Poors Quality Rankings System or any data included therein. Without limiting any of the foregoing, in no event shall Standard & Poors have any liability for any special, punitive, indirect, or consequential damages (including lost profits), even if notified of the possibility of such damages.

34

October 2005 / Standard & Poors Quality Rankings: Portfolio Performance, Risk, and Fundamental Analysis Advisors must distribute this document to clients in its entirety. An advisor can not comment on Standard & Poors investment methodology.

STANDARD & POORS 55 WATER STREET NEW YORK, NY 10041 USA

Michael Privitera (1) (212) 438-6679 Michael_Privitera@standardandpoors.com

For information about contacting our offices worldwide, please view the Contact Us section of www.standardandpoors.com

You might also like