vaughnwoods

The market’s summer rally is as outstanding as it is unsustainable. For this reason, we are taking strategic profits, raising our cash and bond holdings and are now engaging in an asset allocation strategy to reemphasize large quality growth companies. Quality growth companies are defined as having superior earnings growth over the last three years and possessing superior forecasted earnings for the next two years. Quality growth companies also have superior asset turnover relative to their firm’s peer group.

Quality growth is primarily a defensive strategy, having underperformed non-quality growth stocks the last 7 months. However, quality growth companies tend to outperform when lead indicators improve. Lead indicators have risen the last four months.

The following criteria are used by Credit Suisse analysts to screen for quality growth companies:

1) Consistently value creating: These companies have had a higher cash flow from return on investment than their peers at least 8 of the last 10 years.

2) Self financing: High quality companies have positive free cash flows so they can finance expansion, maintenance, research and development and offsets to depreciation

3) Stability: The volatility of the company’s cash flow from return on investment is below the market average.

4) High quality companies do not possess excessively high profit margins. Businesses with abnormally high returns could come under pressure from regulators/competitors.

Credit Suisse research now expects economic momentum will peak sometime between the end of the third and fourth quarters. This is consistent with the expectation by bond experts that global earnings momentum will peak in September / October. Thereafter a slowing in earnings momentum will make it more difficult for small and mid cap stocks to outperform. For this reason we will focus on large cap stocks as lead indicators moderate.

It is also worth noting that the latest reading of the National Federation of Independent Businesses survey, a small business confidence survey, has ticked down, suggesting that conditions are beginning to worsen again for small businesses. This has not happened in the main lead indicators, suggesting that banks, (the sole source of capital for many small businesses) are not interested in helping their debtors avoid bankruptcy.

As for bonds, it is time to start focusing on quality. High yield credit spreads are close to fair value, with implied default rates close to 40% over the next 5 years. This compares to a peak default rate in the last two recessions of around 35%. Concerns have been eased slightly by stronger-than-expected corporate profits, but analysts expect to see credit risk premiums rise towards the end of the year.

In summary, it is time to begin being cautious. It is also time to rethink high yield bond risk taking. Certainly, no one should be playing Russian roulette with individual high yield bonds, no matter how short the maturity. If you must stay in the high yield asset class, use investment structures such as ETFs, closed-end funds, and open end funds which offer protection from lump sum defaults.

Contact Us to learn more about working with Vaughn Woods Financial Group.

Best Regards,

Vaughn L. Woods, CFP®, M.B.A.

*Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views off Delta Equity Services Corp. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0056

**Marketedge.com, Pershing NetExchange Pro, Bloomberg, Credit Suisse
Global Equity Strategy: Erratum: Style monitor: favor quality growth & big cap (Garthwaite, A., et.al, Credit Suisse, 8/21/2009)