When it comes to investing in the stock market, there are many different strategies and factors to consider. One approach that has gained popularity in recent years is focusing on the “quality factor” – that is, investing in companies that exhibit high quality financial and business characteristics.
The concept of quality investing was pioneered by legendary investors like Warren Buffett and Benjamin Graham. The core idea is to identify companies with strong balance sheets, consistent profitability, durable competitive advantages, and shareholder-friendly management teams. By investing in these high quality businesses, the thinking goes, you can earn solid returns while minimizing downside risk.
There is compelling evidence that a quality-focused investment approach can lead to market-beating performance over the long run. Numerous academic studies have found that high quality stocks outperform the broader market on a risk-adjusted basis. For example, a paper by Robert Novy-Marx found that a quality metric combining profitability, growth, safety and payout (the four main pillars of quality investing) would have outperformed the market by over 4% annually from 1963-2013.
So what exactly constitutes a “high quality” company? While there is no single universally accepted definition, most quality-focused investors look at factors such as:
The Definition of Quality
- Return on Invested Capital (ROIC): This measures how efficiently a company generates returns on the capital it deploys. A consistently high ROIC is a sign of a quality business with pricing power and a strong competitive position.
- Debt levels and interest coverage: High quality companies tend to use debt sparingly and are able to comfortably meet their interest obligations. Excessive financial leverage is a red flag.
- Earnings consistency and cash flow generation: Look for companies with a track record of steady, predictable earnings growth and robust free cash flow. Volatile, lumpy earnings are a sign of a lower quality business.
- Management quality: Talented, shareholder-friendly management teams that are skilled allocators of capital are a hallmark of quality companies. Look for a track record of smart capital allocation decisions.
- Sustainable competitive advantages: High quality companies have deep and durable moats that allow them to fend off competition and consistently earn high returns on capital. This could come from brand loyalty, high switching costs, network effects, cost advantages, or other sources.
By rigorously screening for these quality characteristics, investors can construct a portfolio of companies that should be able to compound wealth at an above-average rate over time while holding up better than the market during economic downturns and periods of elevated volatility.
Of course, high quality stocks often trade at premium valuations, so investors need to be disciplined about not overpaying. Incorporating some element of value (e.g. free cash flow yield) into a quality-focused approach can help mitigate this risk.
Additionally, it’s important to maintain a diversified portfolio even when emphasizing quality. Focusing too narrowly on a small handful of stocks, even if they are high quality, exposes you to idiosyncratic/company-specific risk. Make sure your quality holdings are spread across different sectors and industries.
Overall, the quality factor offers a compelling way for investors to position their portfolios for long-term success. By identifying competitively advantaged companies with strong financial characteristics and holding them for the long haul, investors can harness the power of compounding while potentially achieving a smoother ride. As legendary quality investor Warren Buffett once said: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Five High Quality Stocks
Here are 5 stocks the currently score highly using our quality score.
- Apple (AAPL): Quality Score 96
- Apple is a multinational technology company that designs, manufactures, and markets consumer electronics, computer software, and online services. Known for its innovative products like the iPhone, iPad, Mac, Apple Watch, and Apple TV, the company has a strong brand loyalty and a robust ecosystem of services such as Apple Music, Apple Pay, and iCloud. Apple consistently demonstrates high profitability and return on capital.
- Microsoft (MSFT): Quality Score 99
- Microsoft is a global technology company that develops, licenses, and supports software products, services, and devices. The company is best known for its Windows operating systems and Office productivity suite. Microsoft also offers cloud computing services through Azure, and has a significant presence in gaming with its Xbox console. The company has a diverse revenue stream and a strong balance sheet.
- Johnson & Johnson (JNJ): Quality Score 98
- Johnson & Johnson is a multinational corporation that develops medical devices, pharmaceuticals, and consumer packaged goods. The company’s products include well-known brands such as Band-Aid, Tylenol, Neutrogena, and Listerine. Johnson & Johnson has a diversified business model, a history of consistent dividend growth, and a strong commitment to research and development.
- Automatic Data Processing (ADP): Quality Score 99
- ADP is a global provider of human capital management solutions, including payroll, tax, and benefits administration. The company serves over 860,000 clients across more than 140 countries. ADP’s business model is characterized by high recurring revenue, strong client retention, and a solid dividend track record. The company has been consistently profitable and generates robust free cash flow.
- PepsiCo (PEP): Quality Score 97
- PepsiCo is a global food and beverage company with a portfolio of brands that includes Pepsi, Frito-Lay, Gatorade, Quaker, and Tropicana. The company operates in more than 200 countries and territories. PepsiCo benefits from strong brand recognition, a diversified product lineup, and a global distribution network. The company has a track record of consistent earnings growth and a commitment to returning cash to shareholders through dividends and share repurchases.
