What are Quality Stocks? Do They Outperform? What are the Pitfalls?

Quality stocks are a popular type of stock market factor. Quality stocks are generally defined as businesses with above average growth and low default risk.

Based on these definitions, it would sound that quality stocks are always the best ones to own.

But that is not always true.

As with everything in the stock market, factors go in-and-out of favor. While ideally, we’d all hold high quality businesses forever—the reality is sometimes different. The price you pay matters.

To examine what quality stocks are and when to buy them, this post will cover:

Let’s start with the basics.

Introduction to Quality Stocks

A share of stock is a part-ownership stake in a business. It is not a piece of paper resembling a lottery ticket, though sometimes it can seem (and be) that way.

The stock market is simply a place to buy and sell these ownership stakes.

Though the stock market is flashy and can seem like a casino, it really is a place to become part-owner of some of the biggest businesses in the world. As these businesses grow and increase their value, the prices of their shares will generally also increase, over the long term.

The logic says, then: find the best businesses, and your shares will increase the greatest, over the long term.

Some of the best investors of all-time have taken that approach, including billionaire Warren Buffett. As Buffett is popularly quoted:

“It’s far better to pay a fair price for a wonderful business, than a wonderful price for a fair business.”

–Warren Buffett

But don’t lose the inclusion of price here.

Some of the greatest businesses of all-time have been terrible investments, at one point or another. Shares of stock represent businesses, but sometimes these shares can trade at wide gaps between what they are actually worth.

This is because the stock market is an emotional place.

This market, also referred to as Mr. Market by Buffett and others, is greedy and fearful.

This means…

You can buy quality stocks and beat the market over the long term. But you can buy quality stocks and still underperform the market.

Like many things with investing, and life, it’s about balance.

What’s a Quality Stock Actually Defined As?

We can look to some popular stock market ETFs for insight on how investors define “quality” today.

One of the most popular is the iShares MSCI USA Quality Factor ETF, ticker $QUAL.

This is an ETF by BlackRock, the largest asset manager in the world. $QUAL holds some of the best businesses out there today, which include companies like (as of December 20, 2022):

• Home Depot
• Microsoft
• Apple
• Johnson & Johnson
• Visa
• NVIDIA
• Mastercard
• Google (Alphabet)
• Costco
• Nike
• Adobe

Right now the portfolio has 125 stocks and a trailing yield of 1.43% (from dividends). It focuses on large cap and mid cap stocks (bigger companies). How does BlackRock decide which stocks to include in their ETF?

The following three fundamental qualities hold heavy weighting in the decision to include a stock in this list or not:

1. High Return on Equity
2. Stable year-over-year earnings growth
3. Low financial leverage

Each of these qualities deserve a blog post of their own, which we’ve written about on this site already (Return on Equity, Earnings Growth, Financial Leverage).

But at its most basic form, let’s discuss each of these, and why they indicate “quality.”

1—High Return on Equity

The return on equity metric compares a company’s balance sheet and income statement. It essentially measures how much profit a company gets from its investments.

The formula for Return on Equity, or “ROE”, is:

ROE = Net Income / Shareholder’s Equity

Net income is a company’s profits. Shareholder’s Equity, also sometimes called Book Value, is the difference between a company’s Total Assets and Total Liabilities. It is Assets minus Liabilities.

The higher a company’s ROE, in general, the less assets it needs to create profits.

This can indicate quality because the less assets a business needs to grow, in general, the faster and easier it can grow.

When a company doesn’t need many assets to grow, it can pay lots of its profits back to shareholders in dividends or buybacks.

Or, it frees up profits that can be used in the future to acquire other great businesses, which can also turbocharge growth. Examples of acquisitions done well include Microsoft’s purchase of LinkedIn and Google’s purchase of YouTube.

High ROE can be great for shareholders in many ways.

And you tend to see better growth in companies with a high ROE.

Pitfalls with using Return on Equity (#1)

The downside to the Return on Equity formula is that it sometimes doesn’t tell the entire picture of a business.

For example, there are easy ways to “juice” ROE.

A company can simply borrow more and spend the cash, and this automatically increases ROE.

This is because Shareholder’s Equity is calculated by subtracting Total Liabilities from Total Assets. If you increase Total Liabilities without increasing Total Assets, Shareholders’ Equity decreases. And since Equity is in the denominator of ROE, this automatically increases ROE.

Ways that companies can quickly juice ROE by borrowing would be to use the borrowed cash to repurchase shares (“buyback stock”). The buybacks reduce cash (assets), and the debt increases liabilities.

The problem with doing this is that it’s not sustainable over the long term.

Companies can borrow to a prudent risk profile, but anything above that could threaten the long term health of a business. So it’s not a sustainable way to continue to increase ROE.

Pitfalls with using Return on Equity (#2)

The other problem with ROE is that it doesn’t always indicate a company with great growth.

Simply said, a company can keep a high ROE by not reinvesting much.

By keeping Shareholders’ Equity low—by not reinvesting profits—a company can maintain a high ROE as long as its profits are the same every year.

This can make a business’s potential for growth look more capital efficient than it actually is.

Shareholders need to see growth to make market beating returns in the market.

If a company sits on its laurels and does not reinvest enough for growth, shareholders will probably see their share prices also “sit on its laurels” and stay flat over the long term.

2—Stable year-over-year earnings growth

This one is pretty self-explanatory.

Over the long term, stock prices follow earnings growth.

Some investors may measure earnings growth with a company’s Net Income, or Earnings Per Share (“EPS”). Either way, shareholders are wanting to know how much growth in profits their business is generating.

The companies with more stable earnings growth will tend to be better quality stocks over the long term.

This is because the growth in earnings can have a compounding effect.

Bigger growth allows for greater reinvestment, which allows for bigger growth, and on and on. The best companies can also attract some of the best talent (workers and executives), which can spur higher growth still.

Investors also tend to pile on when they see companies with high growth. It can create positive price trends which accentuate the success of the business. This momentum can draw even more traders and investors to the stock.

The reason why quality investors will tend to prefer stable over short term and explosive growth is because it can be a better indicator of a superior business.

Some businesses will be super cyclical, which means their profits rely more on the economic cycle rather than anything else.

A company with huge short term growth may not be an excellent business but rather be exposed to super cyclical markets—such as commodities, homebuilding, semiconductors, and discretionary consumer spending.

3—Low financial leverage

The 3rd and final element of quality stocks is a strong balance sheet.

A strong balance sheet means a company with low financial leverage, which means a manageable amount of debt, and debt + interest payments.

The reasons for wanting strong balance sheets is because it adjusts a business’s success for risk.

Growth doesn’t always indicate a quality business, especially if that growth was all driven by loads of debt. Like we discussed earlier, debt as a growth strategy has a limit. It cannot go on to infinite gains.

At the same time, it’s generally easier for companies to grow with lower debt loads.

Putting less money towards debt means having more money freed up to reinvest. This is true whether a company is investing through its income statement (sales, marketing or R&D), or cash flow statement (capex and working capital).

Having great ROE and earnings growth ALONGSIDE low financial leverage can indicate a company with a competitive moat.

A good, sustainable moat will help a company maintain its profits despite competition.

This is often what separates the good businesses from the great ones.

A good example of a moat would be Apple’s brand and ecosystem. The company’s competitors often release phones with similar technological features, yet their ability to attract customers pales in comparison to Apple’s.

Do Quality Stocks Outperform?

The answer is, it depends.

We can look again to the $QUAL ETF as a reference point to the question (all charts courtesy of stratosphere.io).

$QUAL was formed in 2013. This is hardly enough data to determine its long term performance. But, we can still make some interesting observations.

Since inception, $QUAL has a slight edge against the S&P 500.

However, its performance in 2022 has not been great:

At a time where interest rates were falling, and the bull market was strong, $QUAL handily beat the market:

And yet, if you look solely at the last 5 years (at time of writing), $QUAL is underperforming the market:

This is why “it depends”.

Your performance from buying quality stocks will depend on when you buy them, and at what price because sometimes quality stocks are too expensive, and sometimes, they are great opportunities.

The Biggest Pitfall of Quality Stock Investing

High quality businesses with moats are highly sought after by investors.

As a result, they tend to trade at higher valuations.

In other words, they tend to be more expensive.

The problem with buying quality stocks is that you can easily overpay, leading to underperformance for years. This can be especially true when the market is frothy.

Examples in recent history include Cisco, Qualcomm, and Microsoft. All 3 of these businesses traded at P/E’s in the 50 – 100+ range during 1999-2000. For reference, the average P/E (or Price to Earnings) ratio of a stock historically has been around 15-17.

Cisco, Qualcomm, and Microsoft were among the greatest businesses of their time. They were pioneers of the internet age.

And all 3 of these companies have had fantastic ROE’s, earnings growth, and low debt.

Yet for the 15-20 years after buying one of these quality stocks in 1999-2000, investors did not see great returns. In some cases (Cisco), those investors did not even make their money back.

And this is not just constrained to the dot com bust.

The highest quality stocks in the 1970’s were a bunch called the “Nifty Fifty.” They traded at very high valuations and Wall Street bought them regardless of the price.

Like with the tech darlings of the 90’s, the Nifty Fifty stocks crashed hard in the years to come. This was because even though they were fantastic businesses, they were expensive. Investors paid too much as Mr. Market got too manic. Once reason returned, the stocks traded at prices closer to their true intrinsic value.

Investor Takeaway

It’s easy to get enamored with quality stocks.

So much so, that the success of a business can create a “halo effect” and compel investors to pay any price.

That can be a disastrous strategy over the long term.

Prudent investing means knowing how much something is worth, and paying a fair price for it. If you are basing how much something is worth based on its price in the market, be careful… the market is highly emotional.

Better yet is to buy based on a company’s intrinsic value.

Warren Buffett defined intrinsic value as the present value of future cash flows. Investors today use what’s called a Discounted Cash Flow (or DCF) model to estimate it.

• A quality company will have a higher present value than a poor company.
• A quality company will probably trade at a higher valuation than a poor one.

But the returns to an investor are still dependent on exactly how much cash flow a company is able to generate over the long term. And, at what price an investor pays in relation to those cash flows.

So when you buy quality stocks, remember…

The price you pay still matters.