Which stocks outperform in a recovery?

File this post under “obscure personal finance reading”  or “why dividend stocks continue to be your best bet.” A Swedish undergraduate research paper written earlier this year posed the question of what quantitative measures an investor should look at in determining which stocks will outperform the market in the 12 months after the end of the recession (…and to think I spent 90% of my undergrad on women, drugs and booze and the other 10% of the time I wasted…).

Using a very small sample size of the stock market recovery in the Swedish OMX exchange in the 12 months after the dot com bust, the researchers attempted to look at factors such as price to book ratio, price to earnings ratios, enterprise value/EBIT, debt levels and dividend yields and applied these financial ratios and factors to the study group to determine if tracking any one ratio would give an investor insight into which stocks would out-perform the market in the preliminary stages of a recovery.

The findings came down to three factors which they stressed should not be read together:

1. 12 month trailing performance. The worst the stock performed prior to the market hitting bottom, the more likely it would outperform the market during the recovery period.
2. High dividend yield stocks. Stocks that paid high dividend yields during the downturn tend to out-perform the market during the recovery.
3. Price to earnings ratio. Low p/e stocks tend to do better in recoveries but is a factor with less weight than the other two.

The sample size and study group are far too small to draw any definitive conclusions but the above does make sense. Given that poor performing stocks, which one assumes have lower p/e ratios than their peers with healthier balance sheets, tend to a longer ways to go to recover than stocks that went sideways during the downturn. Thus, when the recovery starts, the relative and absolute bounce is greater than their industry peers.

As for dividends, the paper did not address what a “high” dividend yield was or how high was too high. But, similarly, their findings do make sense. A dividend yielding stock that can maintain its dividend during downturns shows the market that it has its house fundamentally in order and, assuming that investors are more cautious in the embryonic stages of a recovery, there may be an initial overweight towards safer dividend paying stock when cash goes back into equities.

Applied against the run-up since March, what are we to make of all of this? Certainly, low p/e stocks in financial services and oil/gas have made a recovery, returning most of the paper losses for those who hung on. The dividend paying stalwarts of the market also seemed to have held on and done quite well since March.

But, with the S & P 500 p/e ratio at approximately 18, have we already peaked on the stock market recovery?  The stocks that under-performed may have already risen if the S & P p/e is approaching 20 and there may not too much more upside. Contextually, historical p/e is in the mid-teens and a p/e at 20 has never been sustainable for long periods of time.  Predicating the future is a mug’s game but food for thought.

The entire paper on stock market research is certainly very interesting and quite an accomplishment for an undergrad paper.