BANK OF AMERICA: One key part of the stock market is poised to explode higher. Here’s how you can identify those companies and make a killing.

REUTERS/ Gene Blevins

• Low-quality stocks have dominated their higher-quality peers throughout much of the 10-year bull market.
• They’ve been enabled by historically loose monetary conditions that have allowed companies to borrow exorbitant amounts of debt with little recourse in the stock market.
• Bank of America Merrill Lynch argues that high-quality companies are set to outperform going forward. The firm explains why, and how investors can identify them.
• Visit Business Insider’s homepage for more stories.

There’s an old saying that the cream rises to the top.

And while that’s an undoubtedly optimistic way to look at the world, the opposite has been true for the stock market for much of the 10-year bull market.

Emboldened by the easiest lending conditions in history, investors have piled into the stocks of companies sitting on exorbitant amounts of debt. Credit quality simply hasn’t mattered. As a result, so-called low-quality stocks have outperformed.

That’s led to some head-scratching on the behalf of more operationally lean companies devoid of major debt burdens. They’ve done everything right, yet their stocks haven’t been adequately rewarded.

The situation is, for better or worse, the byproduct of loose monetary policy. It’s also aided by an economic recovery that — despite being the longest on record — has been downright sluggish at times, resulting in further inaction from the Federal Reserve.

Put simply, investors haven’t been effectively dissuaded from buying shares of low-quality companies.

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Well enjoy the low-quality renaissance while you can, because it’s on its last legs, says Bank of America Merrill Lynch.

That’s right, BAML is calling for a resurgence of high-quality stocks. The firm has even gone as far as to recommend portfolio managers of all types shift into an overweight position on the group.

A recent client note laid out BAML’s laundry list of reasons for making such a broad suggestion. Chief among them were three main selling points:

1. Corporate profit growth is broadly slowing, putting a premium on companies that can expand earnings organically.
2. Historically low stock-market volatility has nowhere to go but up, and buying quality is an effective hedge against increased price swings.
3. The buy side is still largely ignoring high-quality stocks. When those investors get interested, they’ll represent a strong source of dormant buying power.

Yet while that’s helpful, one question still remains: What exactly does high-quality mean? After all, without a hard-and-fast definition, the entire exercise is worthless.

Fear not, for BAML is here to nail down what makes a stock high-quality. Once armed with this information an investor can then go out, make informed decisions, and hopefully make a killing in the market.

Here are the criteria for high-quality used by BAML:

• S&P Common Stock rankings

BAML defines this as a gauge of the stability and growth of a company’s earnings and dividends.

"We have found that this measure tends to behave predictably depending upon where we are in the economic cycle and where we are in the behavioral cycle, i.e., how much risk aversion or gain-seeking is driving investor preferences, and how plentiful or scarce growth is," BAML said.

• Return on equity

The logic here is straightforward: By definition, the higher a company’s ROE, the stronger its return on net assets. BAML identifies this as an unabashed signal of corporate strength. For the purposes of picking stocks, the firm says investors should focus on the top decile of the S&P 500 for this measure.

• Earnings certainty

This is another easy-to-understand attribute. Sure, sheer earnings growth is great. But a trader seeking high-quality companies should be looking more at how those profits will be affected by a downturn. If a company’s bottom line can stay resilient regardless of environment, that’s a valuable, high-quality characteristic.

For this, BAML looks at the dispersion of next year’s consensus earnings estimates. If it’s in the bottom decile — signifying low variability — the firm counts that among the high-quality category.

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Source: Business Insider – jciolli@businessinsider.com (Joe Ciolli)