Topic: How To Invest

Unlocking Your Investment Potential with High Quality Stocks

Discover how quality companies use their competitive advantages to give you higher returns, lower risk, and strong long-term growth prospects.

Market data and academic studies have established that quality companies perform better than the overall market over long periods. The risk involved in investing in these companies is also lower than the broad market.

Defining quality has common threads

TSI has developed a 10-point checklist of factors that define high-quality, attractive companies. These include a history of generating profits, paying regular dividends, manageable debt, management integrity, industry prominence, the freedom to serve all shareholders, and sustainable competitive advantages that can support outperformance over the long term

MSCI is one of the main providers of indexes that track the performance of high-quality companies. MSCI identifies three characteristics of these companies:

  1. A high return on equity: This indicates a business with sustainable competitive advantages, efficient operations, and above-average profitability.
  2. Stable earnings growth: This demonstrates the durability and stability of a company’s business model through the economic cycles.
  3. Low financial leverage: Companies with low debt have more stability in declining or unstable markets.

Fund manager Fidelity selects what it sees as quality companies based on their profitability, balance sheet strength, and stability of cash flow. Specifically, they look for companies that can generate a return on capital above their cost of capital and have higher profit margins than their competitors.

Index provider FTSE/Russell defines quality companies as highly profitable, with low debt and strong cash flows.

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Fund manager American Century has a different approach to finding the companies for inclusion in their quality portfolio.

First, it identifies those companies that score well on factors that it views as defining quality such as profitability, earnings quality, management quality, and debt. As a second step, it identifies those high-quality companies that offer superior valuations, focusing on those that leverage their sustainable competitive advantages to deliver long-term growth potential. Lastly, it also looks for high-quality companies offering attractive growth potential.

Standard & Poors considers profitability, earnings sustainability, and financial robustness when they screen for high-quality companies.

Generally better returns with lower risks

Over long periods, quality companies perform better than the broad market and generally hold less risk for investors. In fact, over the past 10 years, quality companies performed better than the broad market indexes. As well, the risk, as measured by volatility of the returns (standard deviation) was also lower for the quality companies.

But higher quality comes at a price—the forward price-to-earnings ratio is higher for quality companies than for the rest. The gap between the quality stocks’ valuation and the rest is particularly noticeable for global stocks (not including the U.S.) where quality companies trade at a P/E of 19.0 versus 14.1 for the rest.

Quality does not always win

Note, though, that quality companies do not win every year. In 2022, for example, the “quality” group finished last among the six global factor groups tracked by MSCI. This was counterintuitive as one would expect quality companies to perform better during market downturns.

However, the relatively large positions in the information technology giants, such as Nvidia, Alphabet, and Microsoft, pulled the quality indexes down in 2022.

Still, overall, for maximum gains over time, investors should ensure that quality stocks with sustainable competitive advantages hold a prominent place in their well-balanced portfolios.

What qualities or factors do you personally consider most important when deciding if a company belongs in your portfolio, and how have your criteria evolved over time as an investor?

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