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how to identify quality stocks
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STRATxAI

February 2024 · 5 min read

Quality Stocks

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Educational
Beginner

Quality is another one of the most common equity factors in existence and perfectly reflects its name. The goal is to search for companies that are of the highest quality to investors. Usually this is represented as stocks that have

  • stable cashflows and balance sheet
  • earnings and sales growth
  • strong governance and safe companies

Even though it is popular as an overall concept and factor, the definition of what exactly constitutes a quality company is not easily agreed upon. We have also touched on this idea of the quality factor in a previous topic, that was focused more on factor performance. This post is more about the metrics themselves that our users can investigate to find their own quality companies. Some investors may wish to focus on one facet of quality in particular (for example earnings growth) whereas others may want to focus more on the governance and safety aspect.

Why can't we just find high-quality companies and buy them ?

If only it was that easy! It turns out lots of investors are fighting to find these companies and therefore the highest quality companies tend to have the highest prices and this can lead to lower future returns. The goal is to find the sweet spot of companies that are deemed to be of good quality but also at good prices. There is a famous quote from Benjamin Graham, a famous economist and investing godfather:

The chief losses to investors come from the purchase of low-quality securities at times of good business conditions.

Essentially in order to avoid the greatest losses, it is still better to purchase the highest quality companies at high prices rather than buy cheap companies of really low quality - with the ideal scenario being to find high quality companies at attractive prices.

Data to identify quality stocks

To help filter and find quality stocks, we are first going to construct three broad categories to represent the different traits of quality companies. Then we will give some explicit examples of various metrics from each of the broad quality categories, which we define as:

  • profitability
  • growth
  • safety
Profitability Metrics

Profitability: focuses on a stocks gross margin, return-on-equity, return-on-assets and also cashflow metrics. Higher values of each of these indicate higher quality companies. This makes sense, companies that have a competitive advantage in a sector tend to be able to charge more and increase margins and returns on equity/assets and have strong cashflow.

Examples of some quality metrics for three stocks, IBM, GE and GM
Examples of some quality metrics for three stocks, IBM, GE and GM
Growth Metrics

Growth: identifies companies that are illustrating strong increases in their underlying profitability metrics. For example, companies with a large increase in return-on-equity from last year to this year. Likewise, companies who have managed to increase gross margins since last year would again be ranked as higher quality companies rather than companies who have flat or have lowered their gross margins.

Smoothed change in gross margin for IBM
Smoothed change in gross margin for IBM
Safety Metrics

Safety: measures the volatility, leverage, bankruptcy risk and variability of earnings for example. For this category, we would like to find companies with lower levels of leverage, volatility (outright and earnings) and bankruptcy risk as these would indicate safer companies to invest in and therefore higher quality.

Debt over assets ratio for "safety" quality metric for IBM, GE and GM
Debt over assets ratio for "safety" quality metric for IBM, GE and GM
Combining the quality categories

By using some or all of these categories, investors hope to create a systematic way to identify high-quality companies. The end choice as to how you want to weight each category is up to the individual investor as there is no fixed rule. Clearly, an equal-weight on each individual metric inside another equal-weighting of those three categories is arguably the most consistent. Hopefully this short introductory article describing the quality factor has given you the base to start exploring the data yourself and seeing how to incorporate the quality factor into your investing portfolio.

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