By Jacob Sonenshine
Higher-quality companies haven't produced the stock price returns investors normally expect.
The S&P 500 remains 14% below its record close hit in February, and has seen extreme moves in the past few weeks. Tariffs threaten to slow down economic growth to a degree that Wall Street is still uncertain about.
Classic market theory says shares of higher-quality companies -- those with stronger brands, competitive barriers around their businesses, pricing power, cash-rich balance sheets, and high profit margins -- hold up the best when stocks head south, as they have recently.
The idea is that quality companies can more easily lift prices and maintain their sales figures, making them unlikely to lose money during a recession. They have plenty of cash to weather any reduction to profits, and have access to financing if they need it.
Lesser-quality stocks tend to face greater losses when a recession looms. All things being equal, their earnings and financial positions tend to take larger hits in a downturn.
But recently, quality stocks haven't held up so well. Trivariate Research found that the highest-quality shares have averaged a decline of about 3% the day after analysts cut their forecasts for earnings by more than 5% in response to a quarterly earnings report. That is one of their worst reactions ever.
Usually, quality stocks are flat or even gain after analysts cut their forecasts. Investors often give companies the benefit of the doubt because they have a history of beating expectations for profits, eventually bringing their earnings into line with what the market had expected.
Right now, the market is less forgiving. Part of the problem is that stocks were expensive coming into earnings reports, with valuations reflecting expectations for higher earnings. When earnings fell short, the stock prices had nowhere to go but down.
A prime example is UnitedHealth Group. Thursday, it lowered its forecast for 2025 adjusted earnings per share to a range with a midpoint of $26.25. That was 7% below the consensus forecast among analysts before the earnings news.
Costs rose because customers are visiting care providers more often than management had expected, hurting profit margins. And management forecast about $106.5 billion in sales for the company's OptumHealth segment -- about 9% less than analysts expected. The business accounts for about a quarter of total revenue, so it could cut into total sales for the year by a couple of percent.
The result has been harsh. The stock fell more than 20% Thursday, which is likely to be more than analysts cut their forecasts for earnings. That means the market is pricing the shares at a lower multiple of this year's earnings.
It makes sense because investors aren't sure about UnitedHealth's earnings for the near term. Management said on the earnings call that it is still trying to pin down why medical costs rose.
As of the close on Wednesday, before the earnings were disclosed, the stock was trading at about 19 times the per-share earnings expected for the coming 12 months. That was at the high end of its range in the past year and about in line with the multiple for the S&P 500, according to FactSet.
A valuation in line with the market is about as expensive as the stock has gotten in the past year. It has spent most of that period trading more cheaply than the index, so shares had plenty of room to fall in response to disappointing news.
The takeaway for investors is that the market is moving into a new stage as it assesses what stocks are worth in an uncertain, high-tariff world. Economically sensitive areas of the market were hurt first, but higher-quality and defensive names are now in focus.
Those areas, including healthcare in general and UnitedHealth in particular, were up for the year coming into Thursday, making them more expensive. There's a limit to how high they can go in such a short time.
Thursday's trading is a reminder that one must always be prudent on price when buying stocks. There's a price to pay for everything, even safer shares.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
April 17, 2025 15:14 ET (19:14 GMT)
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