The theory that stocks with superior long-term price stability will outperform stocks with more long-term price volatility has once again been proven during this year’s market rally, and in first-half sales, earnings and cash-flow results.

No simple measure is perfect, however, so the results are averages. In fact, some stocks with superior price stability have performed poorly, while some stocks with the lowest measured price stability have performed quite well.

Similar to previous stability studies reported in this column, a stock’s investment quality is measured by its long-term price movement. Arnold Bernhard, founder of the respected Value Line Investment Survey, made this discovery in the 1930s and 1940s.

In his work, Bernhard developed a simple formula for measuring stock price stability over a 10-year period. The formula makes allowances for secular price trends, up or down, that would otherwise influence the result.

This is the formula used in this recent study. Bernhard’s formula differs from beta because of the formula’s construction, its long-term measurement (beta numbers often cover only a year or two), and Bernhard’s purpose — to identify quality.

As a pioneer in statistical (“quantitative”) analysis of corporate performance, Bernhard found that earnings growth is not as strong an indication of quality as is price stability.

In the recent study, the performance of the 20 stocks with the best price stability and the 20 stocks with the worst stability, as of yearend 2007, were compared. The list was originally published in the May 2008 issue of Investment Executive, and performance was measured over the decade before the 2008 market crash.

In the June 2009 issue, IE reported on how the 20 most stable and 20 least stable stocks from that list had performed, in price, during the market crash. The main finding was that stocks with the best long-term price stability had held up best.

(It must be noted, however, that the list has seen some changes; as a result of takeovers, three stocks had to be substituted for three others in the original two groups of 20 each. The additions were stocks that were next in line to make the original lists.)

Comparisons for earnings and cash flow are not at all neat, because the recession had changed so many positive results to negatives in the first half of this year. That prevents percentage changes from being calculated.

On the face of it, the lower-quality group (least price stability) has performed well. But that’s only because so many had to be excluded from the calculations. Overall, this group has produced poorer results in earnings and cash flow.

Only in sales comparisons between the first quarter of 2008 to Q1 2009 did the least stable stocks do well.

Here is a summary of the com-parisons:

> The most stable stocks, at their high prices this year, were on average 23% below their 2007-08 highs. The least stable stocks averaged 42% below their highs. This is perhaps the most telling comparison of all.

> In comparing year-to-year changes in sales, the least stable (lower-quality) stocks performed amazingly well in Q1, but not in the second quarter. Their sales averaged 10% lower in Q1 compared with 17% lower for the most stable (higher-quality) stocks.

However, the average sales of the most stable stocks increased by 15% in Q2, while sales for the lower-stability group dropped by 15%.

> Comparisons of changes in net income for the 12 companies for which percentage comparisons could be made once again favoured the least stable stocks in Q1. The companies not counted include five in the least stable group reporting losses compared with previous profits. Three firms had losses in both years.

Among the most stable stocks, only two companies reported a loss compared with a previous profit or a previous loss in both periods.

In comparing Q2 earnings, seven less stable companies had losses vs earnings a year prior. Only one company changed a loss into a profit. And one company in the most stable group went to a loss from a profit.

> The same measurement problem of positive results changing to negative ones plagued cash-flow comparisons in Q1 among the least stable stocks. Two had negative cash flow in both periods, and three went from positive to negative cash flow. Two improved from negative cash flow to positive.

@page_break@In Q2, the most stable stocks once again demonstrated their clear superiority. Their average cash-flow change was minus 15%. Only two stocks were uncountable. In the least stable group, with eight of the 20 stocks uncountable, the average cash-flow change was minus 43%. IE