High Quality Stock Investing

Many investors favor high quality businesses. We explore what high quality investing is and how to spot quality when you see it.

Quality: You Know It When You See It

High quality stock investing is an approach that seeks out companies with strong, profitable and consistent businesses. High quality companies tend to be associated with firms that have had an operational history through both good and bad times, showing the ability to weather downturns and grow their business during good times.

Warren Buffett, CEO of Berkshire Hathaway and one of the greatest investors of all time, may be the most famous quality investor. The Buffett quote, “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” shows the emphasis he puts on investing in high quality businesses.  

Like many approaches to investing, quality has evolved over time; initially, quality was mostly derived from looking at financial statements. While many quality investors still look at them today, quality investing has broadened out to include ESG, corporate governance, business strategy and execution, and whether or not a company has high quality shareholders.

Let’s look at a few different ways investors can measure quality.

How Do You Measure Quality?

For some, looking at a firm’s competitive position, market share, management team or even its products and whether or not they are high quality, could impact the perception of being a high- or low-quality company. Businesses with strong competitive advantages that have protective moats around their profitability are often times associated with higher quality companies.

From a financial metric perspective, there are a few ways to seek out quality:

1. Gross Profitability: This figure is measured by taking revenues and subtracting a firm's cost of goods sold. Because there are no other adjustments, this is considered the “cleanest” measure of economic profitability. Academic research has found the ratio of Gross Profits to Total Assets to be one of the best performing quality measures over the long-term.
2. Return on Invested Capital (ROC): This figure gives us an indication of how efficiently a company is using the capital in their business by looking at Earnings Before Interest and Taxes (EBIT) and dividing it by its capital. If we take two similar companies and one has a ROC of 10% and the other 20%, the company with the higher ROC is using its capital more efficiently to turn a profit.
3. Sales & EPS Consistency: Often times, quality companies are in industries and markets that carry less uncertainty. As a result, sales and profits tend to be less variable than other higher risk businesses. One way to uncover higher quality firms is to look at the pattern or variability in sales and earnings. Those firms with the least amount of unevenness in their financial results may be more highly correlated with higher quality firms.

Beyond Traditional Quality Investing with ESG Factors

Quality doesn’t need to be all about a company’s financials and fundamentals. Over the past few years, we have seen more and more emphasis placed on how firms conduct business, treat employees and shareholders and impact the environment. ESG, which is shorthand for Environmental, Social and Governance, is a form of socially responsible, or impact investing, that gives important weight to non-financial factors. These factors are deemed critical for sustainability and success over time as firms focus on their overall impact on society vs. optimizing shareholder value.

From climate change polices and carbon footprints to Board and executive gender and ethnic diversity to corporate disclosures, executive compensation and shareholder impact, ESG is making an impact with investors.

Finding High Quality Stocks in Today’s Market

Investors can take a variety of approaches when looking for high quality companies. Some may prefer a more qualitative approach, while others will utilize fundamental measures and financial strength statistics to uncover quality.

One example of a high-quality company is Apple. Apple is one of the world’s leading technology and mobile phone makers and has become one of the most valuable companies in the market today, largely a result of its nicely designed and well-made products. But quality goes beyond just the company’s devices. The quality of the business is based on its profitability and financial strength and other metrics that make for a high-quality company. Apple has become a top holding for Warren Buffett and Berkshire Hathaway, a further confirmation of how high-quality a company Apple has become.

Quality investing can also be combined with other styles of investing. For example, quality tends to work well when coupled with value investing, which brings us back to the Buffett quote about buying quality companies when they go on sale.

Finding high quality companies using a blend of measures can be a good starting point for investors looking for ideas. We screen for companies using a quality composite, which looks for solid businesses that produce consistent results, are very profitable and generate high returns on their capital employed. Our quality composite combines return on equity, return on total capital, gross margin, net margin and sales and earnings consistency.

See the Top Scoring Quality Stocks in Today’s Market

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