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By Christine Benz | 03-04-2011 09:56 AM

High-Quality Stocks Set to Outperform

With profitability at historical highs, stable, wide-moat companies will see the best returns during the next decade as profits fall at lower-quality firms, says John Hussman.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Morningstar Ibbotson Conference and today I have the opportunity to sit down with John Hussman. He runs very wide ranging portfolios and we got his opinions on a broad swath of different assets classes.

So one thing I want to drill into, listening to you I am not particularly feeling optimistic about stocks but it does sound like you think that the market is kind of bifurcated right now where there are actually relatively attractive areas and then you think the lower quality companies are relatively less attractive. Can you talk about that?

John Hussman: Sure. If you look at large cap blue-chip type companies, Warren Buffett type companies, Jeremy Grantham high quality type companies, Morningstar Wide Moat type companies. All of these fit into essentially the same classification which are consistent revenue growth, broad range of products, stable margins, and normally right now those stocks are trading at very modest price/earnings ratios despite the fact that their earnings are not hyper elevated.

In other words, they are not just showing high earnings because profit margins are really wide. That group of stocks as a whole and there are lots of them within the S&P. I think are priced to deliver perfectly reasonable returns, not necessarily 10%, but certainly in the 7% to 8% range. And there are individual stocks that I do think are priced to achieve better and we try and load the strategic growth fund with stocks like that.

If you look at the broader market than – even the S&P 500 as a whole, one other things that you see is that profit margins right now very wide. One thing we can do is look at profits as a share of GDP historically, what you'll find is that the higher the profits as a percentage of GDP, the lower the subsequent five-year growth rate of profits. That's another way of saying that profits mean revert.

So, we can't just look at an earnings number on the S&P and just blindly apply a multiple without having some sensitivity about where profit margins are. Right now profit margins are very high, partially because of we're running 10% deficits as a fraction of GDP and we've got this enormously accommodative monetary policy that's really helping financials because of the yield curve, as the cost of capital is almost  nothing and you can lend it out at higher rates.

Some of that will go away and so you want to focus on those areas, in my view, where you don't have that sensitivity to profit margin fluctuations if you're also paying relatively high multiples. And I think that's true of those stables sort of wide moats, large cap blue-chip stocks and I am not so sure it's true of the rest of the S&P. I think if you were to take those wide moats out of the S&P, the rest of the index wouldn't perform very well over a decade.

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