Stocks You Should Be Selling

What have been some of the best-performing U.S. stocks this year? According to Morningstar, the top performer through September 24 is Diedrich Coffee (symbol DDRX), up about 5,000% from its December 31 close of 36 cents a share.

Also high on the list are such powerhouses as car renter Dollar Thrifty Automotive Group (DTG), up about 2,000%, and modem maker Zoom Technologies (ZOOMD), which zoomed (naturally) 2,100%. Oh, and by the way, American International Group (AIG), Fannie Mae (FNM) and Freddie Mac (FRE) have risen 43%, 113% and 164%, respectively, this year, despite their well-documented problems.

These are only the most extreme examples of a trend that has dominated the market this year, particularly since the March 9 bottom: The smaller the company or the lower quality the company, the better the stock’s performance.

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Look at the quality rankings compiled by Standard & Poor’s. S&P ranks companies by the growth and stability of their earnings and dividends over the past ten years using a scale of A+ to D. Year-to-date through the end of August, stocks ranked C and D have returned an average of 104%, and stocks ranked B- have gained 54%. In contrast, stocks ranked A+, A and A- have returned 18%, 19% and 23%, respectively.

Results for stocks of small companies tell a similar story. From the end of last year through September 24, Morningstar reports, stocks of small companies returned an average of 30%, while stocks of large companies returned just 17%. Almost by definition, stocks of small companies are riskier than stocks of large companies. They boast fewer product lines, have less access to financing and have fewer opportunities to build economies of scale that protect them from competitors.

What in blazes is going on? Partly, it’s the worst-shall-be-first effect. Stocks of crummy companies and small companies are simply rebounding most sharply from devastating losses during the bear market. If a stock falls 80% and then triples, it’s still 40% below where it started. “The stocks that got closest to death but didn’t actually die have exhibited the best performance since the market turned up,” says Paul Larson, a Morningstar stock strategist. “Returns since the March low correlate with how close to bankruptcy a company got.”

Some low-quality stocks have rallied simply because Wall Street traders and freelance day traders have glommed onto them. These short-termers love volatility. By dint of their volatility, stocks like AIG, Fannie Mae and Freddie Mac have attracted lots of day-trader attention -- even though the latter two fetch less than $2 a share and AIG would be selling for less than $3 were it not for a 1-for-20 reverse split in July.

Stocks of small companies generally lead the market coming out of a recession, but stocks with small capitalizations have become pricey. On average, small caps trade at a 13% higher price-earnings ratio than large caps, according to the Leuthold Group, a Minneapolis-based research firm. Usually, small caps trade at a lower P/E than large caps.

Jack Laporte, who has managed T. Rowe Price New Horizons (PRNHX) for 22 years, is worried about small caps. “It’s a dicier bet than usual to suggest that small caps will outperform over the next two or three years,” says Laporte, whose fund invests in small and midsize companies. Small caps have suffered from “very weak earnings,” he adds. What’s more, small caps beat large caps from 1999 through May 2006 -- an extraordinarily long period of outperformance.

Over the past 80-plus years, small-cap stocks have outperformed large caps. Likewise, stocks of undervalued companies -- those with below-average P/Es and other fundamental measures -- have beaten stocks of faster-growing companies. But each style of investing takes its turn in the sun.

I don’t advocate putting all your money into any one type of stock or another. Notwithstanding last year’s once-in-a-century collapse of practically everything, broad diversification is the only free lunch you get in investing, because it lowers your overall volatility without reducing your returns.

But it is clearly a time to invest far more than usual in high-quality blue chips. We’ve just barely pulled back from the precipice. Federal Reserve chairman Ben Bernanke recently confirmed what we already knew: The nation came within a hair’s breadth of falling into a depression. The financial systems of many nations remain enfeebled.

Overall, I’m optimistic. I think the bull market (see Ride This Bull Market) will continue awhile. But if ever there was a time not to throw caution to the winds, this is it. If the economy recovers more rapidly than most economists predict, stocks of low-quality companies and small companies will likely lead the advance. As an investor, however, I’m willing to give up a few percentage points of return just now to own the most solid companies I can find.

I’m confident that high-quality blue chips will be solid performers in a continued bull market, and I’m even more confident they’ll hold up relatively well if the economic news turns sour.

What should you own? Companies with strong balance sheets, growing earnings, healthy profit margins and the ability to grow even if the overall economy remains in a funk. Among funds that specialize in these kinds of stocks, Fidelity Contrafund (FCNTX) and Primecap Odyssey Growth (POGRX) are my favorite picks.

Steven T. Goldberg (bio) is an investment adviser.