Is It Time To Buy Quality Stocks?

Is It Time To Buy Quality Stocks?
Paul Allison, CFA

over 1 year ago5 mins

  • Investing is about being on the front foot, which sometimes means going against the crowd.

  • And for investors who are thinking about buying into stocks, adopting the quality investing approach might be the way to go.

  • Quality investing is about avoiding the risks that come with deep value or growth investing, and about focusing on predictability.

Investing is about being on the front foot, which sometimes means going against the crowd.

And for investors who are thinking about buying into stocks, adopting the quality investing approach might be the way to go.

Quality investing is about avoiding the risks that come with deep value or growth investing, and about focusing on predictability.

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Let’s cut to the chase, it's practically impossible to time the stock market, and if you’re hoping to hear the Finimize “buy” bell ringing then I’m afraid you’re in for a disappointment. But, if you’re asking yourself whether it’s a good time to think about buying, with so many people screaming “sell”, well then, you might be onto something.

What should you think about buying then?

Investing is about being on the front foot, which sometimes means going against the crowd.

That’s where quality stocks come in. The investing style has fallen behind the broader market this year, as investors have turned to other corners of the market. The chart below shows the iShares MSCI USA Quality Factor ETF (ticker: QUAL; expense ratio: 0.15%) has underperformed the S&P 500 index of large US stocks by four percentage points this year. Not a huge shortfall, but an underperformance nonetheless. And some stocks considered high quality – think Microsoft (MSFT), Alphabet (GOOGL), or Nike (NKE) – have fallen by more.

iShares MSCI USA Quality Factor ETF versus the S&P 500 index. Source: Koyfin
iShares MSCI USA Quality Factor ETF versus the S&P 500 index. Source: Koyfin

But perhaps more importantly, quality stocks have a particular characteristic that makes them well-suited to today’s scary markets: higher predictability or lower risk. Looking for predictable investments is about trying to find certainty that a company’s profits can grow into the future, and avoiding risks to those profits. You’ll find these doctrines tattooed onto the arms of quality practitioners.

Where do you find quality stocks?

The two best-known investing styles are: growth and value. They exist on a valuation spectrum. At one end, value investors look under rocks for companies plagued with problems, usually either stagnating or in decline, but with the hope that things will turn around.

At the other end, growth investors seek the high flyers, buying expensive stocks of companies that are growing like weeds. As for everything in between, stock prices tend to get gradually more expensive as you travel from the dirt cheap to the high-flyers.

Quality investors believe that there are big risks with both the value and growth approaches. They’ll tell you that the problem with down-and-outs is that for a lot of them, nothing ever improves. And in cases where prospects do pick up, investors might have had to wait years to cash in, during which time they could’ve been enjoying nice returns from healthier companies.

As for expensive growth stocks, well, firms don’t enjoy rapid growth forever. Usually, competitors flood the market and start to eat their lunches. So investors can get smacked with a one-two combo if (or when) rapidly growing companies hit the skids and their stock valuations drop in tandem. Just look at the bruises on investors who bought up the so-called pandemic winners like Peloton (PTON) or DocuSign (DOCU).

Quality investors seek to avoid the risks at both ends of the spectrum. What’s left is a middle-ground subset of companies in good health, growing at a decent pace, and trading at reasonable valuations.

How can you choose the winners in that middle ground?

Quality investing is about avoiding the risks that come with cheap no-hopers and over-priced growth stocks, so looking at a stock’s valuation is a good starting point. Using the S&P 500 index’s price-to-earnings ratio (P/E) of 16x as an average valuation for the US market, you can assign a range that cuts off the extremes. Where you draw boundaries is, frankly, arbitrary, but a decent rule of thumb might be five P/E points on either side: leaving a P/E range of 11x to 21x for quality stock fishing.

Let’s take a step back. That P/E range would leave out popular expensive growth stocks like Tesla (TSLA, which has a P/E ratio of 44x) and Amazon (AMZN, a ratio of 76x), as well as practically all banks and commodity companies at the cheap end. But that’s fine: quality investors are perfectly happy to say “not for me, thanks” and move on. Incidentally, the range would also leave out Microsoft (24x) but not by much. Ultimately, where you draw the lines is your choice: you might think a 10x-30x P/E ratio range is better, for example, which would, as it happens, take in Alphabet, Microsoft, and Nike.

Remember: as a quality investor, what you’re really looking for is predictability. And you can gauge how predictable a company’s prospects are by looking at these five things:

1) Valuation.

You want to keep away from the valuation extremes, for all the reasons we mentioned above.

2) Sales growth.

Take a look at the past five years of sales growth, which you can grab from the Markets feature on your Finimize app. You’re looking for decent historic sales growth (say, 5% or more per year) that’s stable. You don’t want to see big gains one year followed by declines the next.

3) Actual profitability.

Companies can be growing but still losing money due to sky-high costs and chunky outlays. You’re not necessarily looking for the most profitable firms, but you want to see that margins are getting fatter over time. So check out the firm's profit margins – profit divided by sales – over the past five years, and see whether they have grown and by how much. Use the Markets tab, along with annual reports or free tools like Koyfin.

4) Competitiveness.

How secure is the company’s competitive position? Are there cartloads of firms that do basically the same thing? If there are, then maybe steer clear.

5) Overall stickiness.

Quality companies tend to have products or services that are sticky, meaning customers either don’t want to switch or find it costly to do so.

Mind you, there are lots of other things to think about as you peer through your quality-investor lens, but with any luck, avoiding the risks inherent with value and growth investing, and following that predictability north star should give you a decent chance of landing on some quality companies that will pay off for your portfolio. So if you’re wondering whether to go against the herd and buy shares today, then quality stocks might just be for you.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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