Investors are increasingly focused on profitability when picking stocks

Fund managers are increasingly screening high-quality companies when making portfolio selections

Most stocks have been in a correction for months, even as the S&P 500 has only pulled back a few percentage points.

Morgan Stanley chief equity strategist Mike Wilson is betting the high-quality S&P 500 is liable to "catch down" to the rest of the equity complex, and when it does, this will be the time to add risk. It could happen fast. It could be a "slow bleed," in his words. But when it happens, Wilson wants investors to be ready and he expects quality stocks to lead the recovery.

Quality stocks, defined as those with superior profitability, strong balance sheets and predictable earnings, are witnessing a breakout in performance, he says. Wilson predicts this trend has further to run as the broader correction in stock markets approaches its end point.

In the weekly warm-up note published every Monday by Wilson and his team, he argues that equity markets have been moving from an early-cycle recovery led by lower-quality stocks into "a more selective mid-cycle environment where earnings durability matters more." The emergence of quality stocks as the part of the market to focus on has been in motion since mid-August with this cohort of companies rallying 6% over that period while the broader equal-weight S&P 500 RSP index has lost around 4%.

Earnings revisions explain much of this trend. Investors have become much more picky about buying stocks with sustainable earnings, margins and cash flow. The gap in earnings revision breadth between high- and low-quality has expanded to 10%, the second-widest since 2010. Historically, when this gap has been in the top quintile, it's led to an average 7.5% outperformance over the following year for higher-quality stocks over their lower-quality brethren.

Composite quality has broken out to a 52-week while the average stock derates.

September's core consumer price index reading of 2.57% year-over-year reinforces Morgan Stanley's emphasis on quality. These stocks are better equipped to deal with rising cost pressures, and the higher interest rates they have brought about.

Looking through the larger-cap names that Morgan Stanley screens for high quality, improving earnings revisions and overweight recommendations from its analysts, names like Alphabet (GOOG), Micron (MU), Broadcom (AVGO) and Apple (AAPL) appear. Stocks with market capitalizations less than $1 trillion but still relatively large would include financials like Visa (V), Mastercard (MA) and Wells Fargo $(WFC)$.

Wilson reiterates a point he made recently that tightening financial conditions continue to do some of the heavy lifting for the Fed and obviating the need for Federal Reserve Chair Kevin Warsh to actually hike the federal funds rate. A stronger dollar DXY, higher energy prices (BRN00) and higher bond yields BX:TMUBMUSD10Y will already be impacting consumer spending habits and causing the tightest financial conditions since 2022.

Financial conditions are the tightest since 2022.

If Warsh were to acknowledge the negative growth effects from tightening financial conditions, it would probably be positive for rate-sensitive areas of the stock market, like financials XLF. If, however, Warsh maintains his hawkish focus on inflation, the rate-sensitive stocks may continue to underperform, he said.

-Jules Rimmer