NEW YORK (CNN/Money) -
Now that the days of skyrocketing earnings seem to be numbered, it may be time to focus less on earnings reports and pick up some new reading material, boring old balance sheets, one Wall Street strategist said Tuesday.
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 | | Slowdown period | | Difference between balance-sheet-driven strategies and income-statement strategies | | June 1988 to Dec. 1991 | +109% | | March 1995 to Sept. 1998 | +49% | | March 2000 to Dec. 2001 | -48% |
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After growing by about 27 percent in the first quarter, earnings of companies in the S&P 500 are expected to grow by about 24 percent in the second quarter and by 17 and 18 percent in the third and fourth quarters, respectively, according to earnings tracker First Call -- not exactly falling off the cliff, obviously, but a slowdown in growth nonetheless.
Meanwhile, the Federal Reserve's target for the fed funds rate, a key overnight lending rate that affects other lending rates throughout the economy, is expected to rise this year.
This is an unusual confluence of events, according to Richard Bernstein, chief U.S. strategist for Merrill Lynch. According to his research, profits usually accelerate as interest rates rise, helping to ease the sting of tighter money and keep stocks afloat.
The combination also means investors might be well advised to put their money in higher-quality stocks, Bernstein said. Last year, when rates were super low and profits were accelerating, investors enjoyed the gains from riskier stocks.
But times of rising rates or cooling profits are usually better for companies with good balance sheets, Bernstein said, and both things may be taking place at the same time this year -- something that's occurred only 5 percent of time during Alan Greenspan's 17-year run as Fed Chairman -- meaning risky stocks will be something to avoid.
"We think it is now time for investors to switch from income statement variables to balance sheet variables when picking stocks," Bernstein wrote in a note to clients on Tuesday. "Portfolios in which stock selection was based on strong balance sheets tend to outperform those based on income statements when the profits cycle decelerates."
Bernstein found that, during other periods of profit deceleration in the Greenspan era, balance-sheet-driven strategies, such as buying stocks based on strong returns on equity, outperformed riskier strategies by some 37 percentage points.
But there was one recent instance of profit deceleration when it didn't pay to look so closely at balance sheets: from March 2000 to Dec. 2001, safer investments lost 21 percent, on average, while riskier investments gained some 27 percent.
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Bernstein said this episode appeared to be an aberration related to the technology bubble, as was the period from Sept. 1998 to March 2000, when profits accelerated but risky investment strategies lost 16 percent.
Still, looking for quality doesn't necessarily mean getting totally defensive; investors may not need to stuff the mattress full of cash and lock everything else in consumer-staple stocks and other safe havens.
"This doesn't mean you have to pour everything into beverages and foods," said James Awad, chairman of Awad Asset Management. "You can still find quality companies that also benefit from an improving economy."
Such companies might be found on Merrill Lynch's list of firms with strong balance sheets, including pricey motorcycle maker Harley Davidson (HDI: Research, Estimates), home-improvement center Home Depot (HD: Research, Estimates), chemical maker Sigma-Aldrich (SIAL: Research, Estimates) and tech firms Intel Corp. (INTC: Research, Estimates) and Dell (DELL: Research, Estimates).
All can be considered "high quality" stocks, with S&P ratings of B+ or better, and all benefit from economic improvement.
If you're feeling totally risk-averse, typical "hunker-down" stocks on Merrill's list include Pepsico (PEP: Research, Estimates), Merck (MRK: Research, Estimates), Johnson & Johnson (JNJ: Research, Estimates) and Exxon Mobil (XOM: Research, Estimates).
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