Quantext, Inc.
March 2, 2010
Looking for quality
US high-quality stocks, on the other hand, are the relative bright spot in Grantham’s seven-year outlook. Examples of companies that he places into this category are Johnson and Johnson (JNJ), Coke (KO), Procter and Gamble (PG), Wal-Mart (WMT) and Microsoft (MSFT).
Grantham predicts that this asset class will return 6.8% annually in real terms – 9.3% nominally. Such predicted out-performance stands in stark contrast to market-capitalization-weighted US equities and even well above emerging market equities.
A portfolio with 20% weighted to each of Grantham’s sample high-quality stocks (JNJ, KO, PG, WMT, MSFT), using the same projection of performance (baseline settings and initialized with three years of data through 2009), produces in QPP a projected average annual return of 8.5% with a volatility of 13%. Using this volatility value as a proxy for high-quality stocks in general, I then convert to Grantham’s annualized return value to an arithmetic average annual return, which comes out to 10.1% per year for high-quality stocks.
A major question is how one classifies high-quality stocks. Grantham provided a set of blue-chip stocks as examples, but that clearly falls short of a precise definition of this asset category. The stocks Grantham proposed are stable, well-run companies that are somewhat insulated from market upheavals. Many such companies can be found among the so-called “dividend aristocrats” (firms that have maintained or raised dividends every quarter for the past twenty five years), and my Monte Carlo simulations have consistently projected above-average returns for portfolios of those stocks. The top ten dividend aristocrats by market cap as of this writing are:
Top Ten Dividend Aristocrats by Market Cap
For a portfolio equally weighted among these stocks, QPP produces a projected average annual return of 11.9% with annualized volatility of 17.5%. Converting to CAGR, this portfolio returns 10.5% – quite close to and even slightly higher than Grantham’s 9.3% projection for his high-quality stocks. The portfolio of these ten stocks is riskier than the S&P500, however. It’s also riskier than an equal-weighted portfolio of the high quality stocks suggested by Grantham.
In an analysis of a portfolio of dividend aristocrats I conducted in March 2007 and again in April 2009, my Monte Carlo projections suggested that a portfolio made of stocks from this group would substantially outperform the broader U.S. market and developed international markets. When I re-ran QPP in February 2010 with the same portfolio of aristocrats from my April 2009 analysis, I once again found expected returns well exceeding the S&P500’s (12.7%), albeit with higher volatility (16.5%). That’s consistent with the analysis in the previous section. The population of aristocrats changes with time, so the consistency between a portfolio of current aristocrats and a portfolio from an older listing reinforces the validity of this approach.
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