What is “Quality Investing”?
Quality investing is an investment approach that seeks companies that exhibit quality or best features. This is closely associated with factor investing (other popular factors include: value, growth, size, and momentum). The main objective is to construct a portfolio of high-quality companies that have the potential to perform well in all market conditions.
Some of the attributes that these “good” companies offer could be a strong management team, a healthy balance sheet, and relatively low debt levels. Quality investing has proven its efficiency over the last decades and tends to deliver more evenly spread returns across business cycles. It also demonstrates defensive features during market downturns without compromising the potential upside capture in rising markets.
Key Learning Points
- Quality investing is an investment approach associated with factor investing
- It aims to identify and invest in high-quality companies that have the potential to perform well in all market conditions
- Quality assessment could be quite subjective, but however, these companies are generally expected to show a number of both quantitative and qualitative attributes
- These attributes include: sustainable earnings and revenue streams, efficient business models, and brand power
- This approach is suitable for investors with a long-term time horizon and a balanced risk profile
How Quality Investing Works?
Quality stocks typically produce persistent returns which are valued by investors with a long-term time horizon. This type of investing style tends to capture the more premium stocks in the market. Investors are often willing to pay more for stocks that deliver consistent returns. The opposite of quality investing can be selecting unloved, underperforming ‘value’ stocks which often need to see a structural improvement in either market conditions or their own operations before the share price is likely to outperform.
Quality companies usually have strong business models and competitive edge within their industry, which are already successful and deliver returns in excess of the market. Therefore, they are expected to continue being ahead of their peers and offer higher returns for longer than the market expects.
Although higher short-term returns could lift their share price up to and make them look more expensive, the market might tend to under-appreciate the persistence of their returns. As a result, should these companies deliver them year after year, investors are likely to re-assess the stock, which on the other hand could be the driver for outperformance.
How to Identify a Quality Stock?
Appraising the quality of a business can be quite subjective as it can be based on soft and hard criteria. Best practices suggest that they should be able to demonstrate:
- Good management: that has the ability to recognize potential opportunities and capitalize on them. Typically, that should be companies with low staff turnover, particularly at a senior level.
- Strong balance sheet: that could withstand unfavorable business and/or market conditions. Usually, these stocks have lower debt levels – Debt to Equity and Interest Coverage ratios are two of the most common ratios that investors pay attention to.
- Earnings stability: this, in theory, lowers the risk of forecasting errors and can make earnings projections more predictable. Investors who favor quality investing may be willing to pay more for this predictability.
- Having a strong track record of paying (ideally growing) dividends: is another characteristic of a quality company. In addition, this could suggest a strong management team that strives to create (and continue to deliver) shareholder value.
- Reinvesting profits: alongside distributing dividends, quality companies also need to make sure they invest some profits back into the business. This is to sustain their market competitiveness by continually developing new products and services, implementing new technology, and continuing to improve business efficiency. The Return on Assets ratio could be a good indicator for the latter.