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October 2005
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,
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.
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.
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.
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.
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
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
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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
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.
1.0
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.
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%
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.
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11
A+ A AB+ B BC
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%
* Excludes Financials and General Electric Co. due to its large financial business
12
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A+ A AB+ B BC
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.
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13
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
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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%
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.
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100%
1.8
15
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.
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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.
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V. Quality of Earnings
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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
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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.
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V. Quality of Earnings
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.
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QUALITY RANKING
PERCENT OF TOTAL
PERCENT OF TOTAL
PERCENT OF TOTAL
A+ A AB+ B BC
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.
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A+ A AB+ B BC
42 35 31 28 23 12 3
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.
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A+ A AB+ B BC D
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.
18 High Quality Rankings stocks as a percentage of total for the S&P 500.
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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.
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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
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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.
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A+
20.0%
25.0%
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.
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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
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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.
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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.
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References
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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.
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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.
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