While it has usually been wise to focus on companies with highquality business models and strong management track records, we believe that these factors are even more crucial now because of where we are in the economic and corporate-profit cycles. In addition, US companies are facing an array of headwinds that include US-dollar strength and potentially slowing export growth.

RISING REWARDS FOR MARGINS

Notably, while many in the financial media are focused on the macro-related headlines—China, Federal Reserve rate hikes and falling oil prices—the underlying market has been differentiating between strong fundamental results at a stock level. Adam Parker, Morgan Stanley & Co.’s chief US equity strategist, notes that correlations have been declining since July 2012 and stock-specific risk is about 52%, near five-year highs. These trends were on display throughout second-quarter earnings season as companies that beat analyst estimates were up by 1.7% while the penalty for misses continued.

Moreover, companies that expanded their profit margins were rewarded. In the three days after the earnings announcement, companies with margin expansion were up an average 0.54% while those with margin contraction were down an average 0.61% in the same three-day period. The ability to continue to generate margin gains amid an environment with heightened volatility and anemic revenue growth—second-quarter S&P 500 revenue growth was 3.1%—will likely be an important measure of performance going forward. Therefore, it is crucial to focus on management teams with superior track records that have demonstrated the ability to navigate this environment through cost cutting and productivity initiatives.

QUALITY FACTORS

In addition to management execution, Parker notes that, during periods of rising stock-specific risk, factors such as the ratios of enterprise value to free cash flow and enterprise value to earnings before interest, taxes depreciation and amortization are the most compelling. Also important are accruals, which are the difference between earnings and cash flow. Stocks with lower accruals—their earnings are closer to their cash flow—tend to perform better than companies with higher accruals, where a greater portion comes from noncash sources. In effect, accruals measure earnings quality, which has been a useful factor over time. Other measures of quality include market cap (larger companies are higher quality), stable earnings, stable return on equity, higher net margins and higher return on equity. Stocks of high quality have been outperforming low quality, or junk stocks, since May (see chart).

SECTOR FOCUS

From a sector perspective, Parker’s analysis suggests that the best opportunities are in tech, retail and energy. Within tech, the spectrum includes “old tech” (cheap with secular growth challenges) and “new tech” (richer valuations but more robust secular growth). We have a bias toward “mid tech” at this stage: large-cap companies with growth-at-a-reasonable-price valuations closer to the sector average, strong balance sheets and consistently high but not hyper earnings outlooks. This includes payment processors, mobilephone makers and internet advertising.

In retail, we favor restaurants, club discount stores and home-improvement players with high brand loyalty and consistent sales growth. Importantly, we like retail companies that are not just insulated from e-commerce threats but are investing in technology to create new revenue opportunities.

Finally, the charred energy sector is an area where quality and execution are paramount. We favor exploration-andproduction and oilfield-service companies with diversified asset portfolios and strong balance sheets. They should also have solid managers who are able to cut costs and protect margins amid the current commodity downturn and get their companies well positioned for an eventual oil-price recovery.