What Is A Quality Stock And When Are They Buys

I recently wrote an article, “The Generation Portfolio,” in which I set forth my goal of finding quality stocks for an account I am setting up from scratch. Since I did not explain there what I meant by “quality,” and instead only gave a list of stocks that I considered quality plays, someone asked me what I meant by the term. Since we are all looking for quality plays, below I will set forth my own ideas of what I consider to be quality plays, and when they are – and are not – attractive pick-ups.

What is a “Quality Stock”

The term “Blue Chip Stock” came out of the 1920s, when Oliver Gingold of Dow Jones coined the term based upon the use of blue chips in poker for the highest dollar amounts. Generally, the term is used for stocks that are considered to be of the highest quality. In the past, the stock of companies such as IBM (IBM), General Motors (GM) and General Electric (GE) were treated reverently as the ultimate Blue Chips, producing high returns year after year. They became household names, and the best of the best received the even higher accolade of “Bellwether Stocks,” meaning they were considered leading indicators for the market as a whole. A few decades ago, for instance, radio reports regularly would report how IBM was doing along with the major averages.

Just throwing a term around and applying it to certain companies, though, doesn’t explain what the term actually means or make it useful. Beyond the amorphous attributes of being successful and well-known companies, there is no hard and fast definition of Blue Chips. We can, however, come up with a working definition for our own use, and we will call them “Quality Stocks.”

The Importance of Brands

Brands distinguish one product from another. As customers use a company’s product, they form impressions about the product’s quality and value. Over time, those associations transfer to the name of the product itself, and thence to the company. That is how a brand is built.

A brand can come to stand for an entire industry, which is the Nirvana of branding. Examples are “Xeroxing” for paper copying, “coke” for soft drinks, and “Kleenex” for hand tissues. A more recent example would be “googling” for performing an online search. Nobody has enough money to convince people to use a company name for a common activity, that has to come from the product’s intrinsic quality.

It takes a lot of time, money and awesome execution to create a top brand. Some of the best brands become global, such as Disney (DIS) and Apple (AAPL). Along with Coke, those in my opinion are the most famous brands in the world. However, there are quantifiable ways of quantifying a brand’s value, and it is not just a matter of opinion.

Forbes lists the most valuable brands as follows:

1. Apple
2. Microsoft
3. Google
4. Coca-Cola
5. IBM
6. McDonald’s
7. Samsung
8. Toyota
9. General Electric
10. Facebook
11. Disney
12. AT&T
13. Amazon.com
14. Louis Vuitton
15. Cisco
16. BMW
17. Oracle
18. Nike
19. Intel
20. Wal-Mart
21. Verizon
22. American Express
23. Honda
24. Mercedes-Benz
25. Budweiser

The main tip-off that this is a solid list is that you probably recognize every name on there. People around the world also will nod their heads in recognition at Honda or Nike or any of the other names. When someone in Russia recognizes a company’s name just as much as someone in Texas, you have something of truly lasting value.

A Good Brand Is Not the Same as a Good Stock

Just because a brand is a household name doesn’t mean its company is a good value. Kleenex is a registered trademark of Kimberly-Clark Worldwide, Inc., and everyone knows what a kleenex is. Now, Kimberly-Clark Corporation (KMB) is a fine company whose stock I personally like, but having a top brand doesn’t mean that anyone need rush to their broker to place an order to buy the company. A top brand is just a starting point when identifying quality stocks.

Brands evolve over time. Several of the top brands listed above didn’t even exist 20 years ago, such as Google (GOOG)(GOOGL) and Facebook (FB). Others go back over a hundred years, such as General Electric. Age alone has something to do with it, but new top brands burst on the scene with regularity. A company that dominates a valuable niche will quickly become a top brand. The Internet as we know it is barely 20 years old, yet there are several purely Internet-based companies among Forbes’ list of top brands. That shows how quickly a top brand can be established – or fall off the list.

Determining which company will dominate a niche and provide the most valuable service within it can be tricky unless the company has been around for a hundred years. Everybody recognizes that General Electric, established by Thomas Edison, dominates its field, but Facebook came to prominence less than a decade ago when it surged past MySpace, which previously dominated the social media niche, around 2009-2010. Now, MySpace is an also-ran and Facebook is on the list of top brands. It is important to do due diligence to make sure that a brand is healthy.

A dominant company need not have monopoly-like characteristics. BMW is a great car company, and is no. 16 on the Forbes brand list, but it isn’t the world’s largest auto manufacturer. In fact, it isn’t even number two or three. The top five car manufacturers in 2015 are:

1. Toyota Motor
2. Volkswagen
3. Daimler
4. BMW Group
5. Honda Motor Group

Thus, a top brand can be an also-ran within its industry, but produce something of such quality or renown or usefulness that it still is recognized as a top worldwide brand.

Toyota, the top auto manufacturer, is no. 8 on the Forbes brand list, is the top auto manufacturer (though Volkswagen may be taking that spot over), and is publicly traded. However, that does not automatically make it a top stock to pick up at any random time. Toyota stock fluctuates like any other. Another example is Twitter (TWTR), which is a top player in the social media field and is quickly becoming a household name (if it isn’t one already). However, its stock currently languishes due to issues at the company.

Another example of a Quality Stock that does not necessarily dominate its niche in quantifiable terms is Wells Fargo (WFC). The world’s largest banks in order are:

1. ICBC, China
2. China Construction Bank, China
3. Agricultural Bank of China, China
4. Bank of China, China
5. JPMorgan Chase, US

Wells Fargo isn’t even on that list – well, ok, I cheated a bit, it comes in at number 6. However, Wells Fargo is not the world’s biggest bank, and it isn’t the biggest in the United States, either. There are many other dominant banks in the US, such as Bank of America and Citigroup, and few would claim that Wells Fargo “dominates” either global or domestic banking (outside of WFC headquarters). However, on the other hand, few would argue that Wells Fargo isn’t also a Quality Stock with consistent performance metrics and a venerated brand that, at the right price, could fit comfortably into most portfolios.

A Quality Company that has a top brand becomes a good stock (assuming it even trades publicly, many top brands are privately held) only after the market decides that the company’s success is assured and it will durably maintain its niche for the foreseeable future. It also helps if the company has worked out all of its internal issues and is on a quantifiable glide path to success. We will assume that normal due diligence does not turn up any major problems with the company, that it is not facing secular declining demand or anything like that.

However, even a good stock of a Quality Company isn’t always a good buy. That takes another level of analysis and timing which in fact is the most important step of all.

The Best Times to Pick Up Quality Stocks

Now we have a working definition for a quality stock:

For our purposes, a Quality Stock is a household name that dominates its niche or which is so entrenched due to the quality of its services that its prosperity appears to be assured for the foreseeable future.

Just having a working definition and knowing how to pick out a Quality Stock, though, does not mean that they are always good buys for the average trader just looking to pick up some shares to make a buck. These types of stocks go through all sorts of cycles, and there is no mystery about some brand-name company. Everyone knows the brand names just as well as you do, that’s why they are top brands. The trick is to pick up Quality Stocks at the right time. That, in fact, is the whole trick to prospering from this type of play. You know from the brand and your due diligence that the company will be around in five years, but you must also gain an edge in terms of price.

Unfortunately, the right time to pick up a Quality Stock doesn’t come along all too often, but such times do come with great regularity. Those opportunities can be years apart, but they are like Haley’s Comet in terms of regular appearances. If you are lucky enough to pick up a Quality Stock at the right time, your portfolio will have low risk for its returns and enable you to indulge in more speculative plays without incurring too much overall risk if that is your wish. The Quality Stocks will form an anchor which keeps your overall portfolio from drifting onto the shoals even during market hurricanes. Risk analysis is a whole other topic, but any risk expert will tell you that minimizing risks while maximizing returns is the true path to prosperity.

Let me be clear: I do not recommend buying Quality Stocks at any old time. They can and will become overvalued and lead to mediocre returns if you buy at those points, quality or not. My favorite example is Disney around the turn of the (recent) century, though there are many, many examples.

Disney stock, 1996-2006.

For my money, Disney is one of the best stocks that you can own, but not if you buy it at the wrong times. One can easily spot from the chart the best times to buy Disney, and also the worst, and hindsight is 20-20. However, as discussed below, identifying good times to pick up a stock like Disney is not beyond the reach of the ordinary investor.

Just as Quality Stocks provide regular buying opportunities, they also provide extended periods when they are over-bought. For Disney, the stock price went basically nowhere over the decade shown, and shortly thereafter fell off the Financial Crisis cliff. Much of this was during the Disney Renaissance, when every animated film that it released seemed to become another blockbuster. In addition, the growth of cable and its theme parks made the company a money machine. Unfortunately for new buyers, though, the stock price became a victim of the company’s fame and success, and too many people piled into it. The stock price soared beyond all reason.

However, if you had bought at the right times, even during the period shown, you would have made good returns. It is not luck, or should I say not just luck (because we all need a little luck in life), that determines good entry points. The market provides clear signals as to the best times to enter Quality Stocks.

Here is my own working definition of the best time to pick up Quality Stocks like Disney:

The best times to pick up Quality Stocks is when there is a general market sell-off and practically everything sells off regardless of quality or value.

In fact, general market sell-offs are the only time I consider picking up Quality Stocks. They are usually over-valued when the market is rolling along under blue skies. The rest of the time, other consideration such as the cash flow a company provides take over, and it is better to focus on other strategies.

Why Quality Stocks Are Good Buys During General Market Sell-Offs

There are three main reasons why Quality Stocks become the right choice during market sell-offs:

• Durability;
• Index Funds;
• Buybacks.

The first reason to pick up Quality Stocks during market sell-offs, their durability, is actually psychological. Durability means that the market previously vetted these stocks and found them to represent premium companies. The company has a top brand, and the market has passed its judgment according to our criteria that it is a Quality Stock. A Quality Stock is always desirable, the only sticking point is price. Aside from individual company issues, only during a general market sell-off are you likely to find a Quality Company truly on sale.

The durability is important psychologically because knowing about it will help you to steel your own nerves to buy it when your natural inclination is to sell everything and go hide under the bed instead.

I was tempted to use the word “unassailable” instead of “durable.” However, nothing is unassailable. Just ask General Motors shareholders from during the Financial Crisis. There are real risks during certain types of sell-offs, you always have to avoid company-specific issues and the like. There are no sure things in life. The key is to identify whether the reasons underlying the sell-off will impact a particular Quality Stock in particular, and if so, choose another.

Market sell-offs occur because people panic. There’s no better way to put it: investors get frightened by this, that or the other transient thing. October 2014 is a prime example: the market sold off due to Ebola fears of all things. Naturally, once the Ebola scare passed, everyone piled back into the Quality Stocks.

The Ebola Scare was a time to gather your courage and buy some Quality Stocks. We are not immune to the fears that grip the market; to assume that we are all emotionless robots is ridiculous. Embrace your natural emotions, there is nothing wrong about them. Market sell-offs happen precisely because people like us get scared. Recognizing that is part of the solution.

While we are in the midst of being terrified of the scary market drop, that is the time to find the port in a storm, to carry on our nautical analogy above. Market drops make us fear that there “is no bottom.” Quality Stocks, though, aren’t going away due to an Ebola Scare or whatever, any more than quality real estate became any less so during the Financial Crisis and accompanying bursting of the real estate bubble. Quality is quality, and, as the saying goes, quality will out.

It will be easier for you to buy a Quality Stock even in the grip of whatever fear you feel. That is the time to reach out for the life raft that is a Quality Stock, because you know deep down that they are durable and will still prosper long after the fear departs.

The second main reason to buy Quality Stocks during market sell-offs is more technical. Index funds have grown in popularity through the years. As I wrote in my recent article “The Hidden Danger of Index Funds,” the default investment for over half of equity fund purchases in 2014 was index funds.

We can all argue, as I did in my article and the accompanying comments, about the meaning of this trend. Opinions will differ about the effect of index funds on the market and individual portfolios. However, I have learned that fighting a market trend is just asking for trouble. The better tactic is to figure out how to prosper from it. The way to prosper from this growth of index funds is either to buy an index fund yourself, which is probably not your choice since you are reading this article about picking individual stocks, or to understand what they are doing to the market and trade accordingly.

Index funds are being pushed by just about everyone these days. There are articles entitled “Your Friend, the Index Fund,” and Warren Buffett repeatedly has touted index funds as the best choice for most investors. Many office workers in 401(k) or other retirement plans have no good choices aside from index funds. It is a fact of life: index funds are taking over the stock market.

We all know the basics of index funds: they hold baskets of stocks chosen by someone in an office somewhere, with regular additions and deletions based upon arcane and often mysterious criteria. To say that index funds are completely mechanical is nonsense: one way or another, someone is deciding what goes in them, not some machine. There are a lot of myths about index funds that badly need dispelling.

The key fact for our purposes, though, is that many index funds hold the Quality Stocks that we want. The people who own those index funds are just like us: they are as scared by Ebola or the Fed as we are. While I never quite figured out the connection between Ebola killing everyone and the need to sell your stocks, what happens is that people get scared and they hit the button to sell what they own; and, increasingly, what they sell is their index funds because these days that is what everyone owns. Of course, when the fear subsides, they eventually buy back the index funds (at higher prices).

Now, someone could love Apple, and even own shares of Apple that they would never, ever sell. They may have five iPads and six iPhones and even wear the Apple Watch (I have never met anyone that does, but maybe I just don’t get out enough). Anyway, while they would never sell their precious Apple stock, they most definitely would sell their index fund that has a 5% component of Apple stock in it. After that, the sell programs take care of business.

Have the perspective to realize that a sudden wave of program selling, such as hit the market almost precisely at 3:00 p.m. EST on Tuesday, 25 August 2015, is most likely the summation of fears of the index people. Far from being a harbinger of the next stage down, it reflects past events that, scary as it seems at the time, is like the conclusion to a good novel: it strikes an emotional chord, but then it is over. By washing out the weak hands, it sets the stage for a foundation and perhaps a market rebound.

The moral of the story is that during market sell-offs, no matter how beloved a cult stock may be, the iWatch will get thrown out with the bathwater as people give in to their irrational fears and sell their index funds. That is the moment of opportunity for those who want to own Quality Stocks.

You will find the run-of-the-mill also-ran stocks on sale throughout the year. Buying one of them during a market panic likely is a wasted opportunity, like being first on the long line for the buffet and then only grabbing a coke. Generally, it is only during periods of panic selling that you will find the true bargains in Quality Stocks, and that is the time to focus on them and buy them.

It is like buying a nice suit. You can always go to whatever store is at the local mall and pick up something that is on “sale” every weekend. Or, you can wait for the once a year sale at Brooks Brothers and find something really nice that you’d definitely pay more for every other time, and that you’ll keep handy in your close for the next 20 years.

The opportunity can be fleeting. For instance, during the Ebola Scare, the market recovered within a couple of weeks as if nothing had happened and soon went on to all-time highs. There are many reasons for these sell-offs, and they are all scary enough to make ordinary people panic: China, Iran, terrorism, the Fed, creepy diseases, whatever it is. However, at least to date, all such market troughs have disappeared after some time has passed and investors have regained their faith in the future.

The third reason for buying Quality Stocks during major sell-offs is one of the factors which keeps such opportunities fleeting. There is usually one major group of investors in these companies that is always watching, is completely unemotional, and couldn’t care less about Ebola or whatever else has sent the stock market reeling.

This major group of investors is the companies themselves.

Now, insiders are one thing. They can be as terrified as anyone for the future of the stock market and of western civilization due to whatever Janet Yellen might say on some hot September day. However, the corporations themselves are ready with their share repurchase authorization whenever their stock price falls below certain metrics. It is much easier for some corporate functionary to be dispassionate about investing the company’s money in the market during such occurrences than their own small personal stash. They are a major source of new funds into the market during such occasions.

There was clear evidence of this during the most recent major sell-off, in late August 2015. Due to a combination of Fed fears and worries about China, the major averages staged their first real correction since 2011. The market dropped precipitously on Friday, 21 August, and after a weekend of anxiety by multitudes of small investors, staged a good imitation of a flash crash on the following Monday morning. Tuesday was an up-and-down day that suggested the panic at least was abating, but the market remained edgy.

So who stepped in on Wednesday? The corporations themselves. The Goldman Sachs unit that implements corporate buybacks saw “record volume” that day, stabilizing the market and igniting a modest snapback rally. Many people are quick to ascribe seemingly magical market intervention that stops major sell-offs to the government, but in fact it is the corporations themselves who serve as the true “plunge protection team.” In truth, it is the cheap money provided by low interest rates that provides some of their ammunition, but it is the Quality Companies who are most likely to have ample cash and procedures ready for such occasions. That is one of the benefits of being a Quality Company which has proven over time that it knows how to execute when it counts.

The time to buy the Quality Stocks is while others (and perhaps you) are panicked about the latest scare and before they (and you) fully recover. To do that, all you have to do is overcome your own fear and grab the brass ring while it is still available. Turn off the television telling you how terrible everything is, bring up your broker’s screen, then place the buy order for the Quality Stock you’ve researched and know you want.

Then, jump up from your machine, go running through the streets screaming in terror along with me and everyone else. Just hold those Quality Stocks for dear life until the good times resume. You’ll feel great counting your profits while you prepare for the next panic.

So, What are the Current Quality Buys of Quality Stocks Then?

I, and of course many others, publish all sorts of articles about what are good buys at any point in time. A good buy of a Quality Stock depends on price action as well as the fundamentals. My common practice is to stay up to date on the fundamentals of Quality Stocks even when I’m not interested in buying them. That way, when we get a scary sell-off as happened on 24 August, there is no hesitancy: the only thing to decide is whether to pull the trigger at a particular price, not whether the stock is worth owning at all.

During market breakdowns, look for Quality Stocks whose business is in good order that are heavily represented in the major indexes. They will suffer the most from index herd selling, and they will benefit the most from the inevitable herd buying that will happen when fear subsides.

So, the current quality buys are always a subset of the Quality Stocks, and sometimes (actually, much of the time) there aren’t any stocks in that subset at all. Of course, it comes down to your own particular investing style and situation and so forth which are the best Quality Stocks to add. For my own current ideas, check out my other recent articles, but nothing replaces performing your own scans and due diligence.

Please Put It All Together In One Sentence

During major market sell-offs, take advantage of the herd behavior manifested in index fund selling by considering companies with top brands that have a durable niche within their sector.

Conclusion

Quality stocks are those of companies that have top brands and have dominant or at least durable positions within their niches. Quality Stocks regularly go on sale during market panics, but the intervals between such sales can be widely dispersed and they come unexpectedly. Corporate buybacks can swoop in when values get abnormally low. The key is to take advantage of the fear manifested in sell programs that reflect index fund selling.

During normal times, Quality Stocks tend to get over-valued (such as with Disney in the example above) because everyone recognizes their value and is complacent about market dangers. Thus, in general, Quality Stocks should be avoided when the market is grinding higher without a care in the world. However, it still pays to do your due diligence on Quality Stocks during the good times so you are ready to buy them given the right opportunity. If you are brave enough to focus on Quality Stocks during periods of market turmoil, over time you are likely to be well-rewarded.