In light of the rally that began in October, one of the strongest one-month performances in many years, investors may be looking ahead to a market recovery. Here at CALAMOS INVESTMENTS, we still maintain that the underlying economy is stronger than the media or the markets have made it out to be, but we found little in October's boom let to support the argument. While our belief in the economic recovery is firmly rooted in the prospects for strong, higher-quality companies to grow their earnings, the recent upturn in the indexes looked more like a bad-apple bounce, with the lower quality, negative earners leading the way.
For example, companies given a "C" by S&P stock ratings, the lowest rating in their Earnings and Dividend Quality ranking, out-legged higher-quality companies in October, averaging a 19% gain. Put another way, the Russell 2500 Index's 50-best performing stocks in October can claim an average P/E ratio of negative 10.8, having lost an average of $2.13 in earnings per share over the trailing 12 months. However substantial their one-month's gains, these lower-quality companies have clearly been a source of capital depletion for longer-term shareholders. Furthermore, their forward-looking prospects offer neither stability nor absolute growth of earnings, despite the recent price run-ups.
It's worth noting, however, that in past downturns, the type of price action recently exhibited often occurs at the turning points in the markets. Even such short-term positive reactions may signal a much better market for the coming months. Other signals we are on the watch for as confirmation of a positive trend include: shifting of assets from investors' flight to quality back to riskier assets; narrowing credit spreads; reduced market volatility; positive returns in emerging markets; and rising US government bond yields. While no single factor can proclaim the market's transformation, as these signals mount, both in number and degree, the recovery should gain momentum.
It may be heartening to see some prostrate companies climb to their knees, but our view on a recovery and how to participate in it focuses on companies that have the potential to be drivers, not bystanders, of future economic growth. Across our strategies, whether in the equity, convertible, or high-yield arenas, we employ screens based on credit analysis, which cull the weakest, least reliable companies from contention. Our requirement for strong balance sheets has helped us build portfolios that historically have withstood downturns well, typically losing less than either their competitors or the relevant indexes during a down phase of the market cycle. In all strategies, we believe that sustainability of earnings growth as well as relative dominance in an industry are the keys to downside protection as well as drivers of long-term gains.
Although our emphasis on balance sheet strength did not especially benefit our performance relative to the benchmarks in October, the focus helped to provide protection during the market's downturn, thanks largely to the less-extreme price declines of our more resilient holdings. Now, as the economy grudgingly moves toward recovery, we look to their potential for gains, too. Currently, our positioning for a recovery-driven economy centers around two types of companies: the industry leaders, and the survivors.
The former group, which has been the mainstay of our portfolios since the demise of the bull market, offers strong balance sheets, high cash flows, and the potential to hit the ground running when the recovery takes hold. The second group, the survivors, is becoming a greater portion of our investment team's focus. These holdings come mostly from economically sensitive, beaten-down sectors, yet their balance sheets suggest that they are strong enough to at least survive unlike many of the top performers in October. Gains from this group will be made on yields, reversion to fair values, and an improvement in prospects if the recovery spurs a narrowing of credit spreads a typical outcome of a strengthening economy.
Indeed, until credit spreads do narrow and businesses get better access to capital, we feel that the markets are somewhat hemmed in because capital constraints are keeping a fuller recovery at bay. However, the combination of broader-based equity gains and an easing of credit concerns could become the underpinnings to support a well-founded recovery. Our portfolios are being positioned to participate in multiple aspects of such a scenario. Together, by selecting both the leaders and the survivors for each of our portfolios, we are positioned for full participation in a recovery economy, with the ability to "wait out" the still-slow recovery process.