Illustration by SHOUT
By Carla Fried
January 12, 2016

As the architect of your stock portfolio, you are in charge of making key design calls. You might favor large companies or small ones. Or you could decide between bargain-priced value stocks and more expensive growth fare. But there’s another factor that deserves more of your attention: a company’s quality.

Stocks with high-quality marks not only deliver superior long-term performance but have also shown less volatility than stocks overall. And as it happens, now is an especially good time to upgrade the caliber of your portfolio, as volatility has been on the rise amid worries over the health of the Chinese and global economies.

What defines quality? It’s shorthand for a company with strong and dependable profits, not too much debt, and a dominant market position it can defend from the competition. Think of the diversified health care giant Johnson & Johnson JOHNSON & JOHNSON


JNJ
0.57%

, with over 25 straight years of rising dividends, or brand-name stalwarts such as Coca-Cola COCA-COLA COMPANY


KO
-0.45%

.

Quality sounds like something every investor would want — indeed, famed investor Warren Buffett is a longtime quality advocate. Yet it can go in and out of style.

The bull market that began in 2009 gave a huge boost to low-quality companies, which have returned an annualized 19.6%, compared with 13.7% for the top-shelf firms. During rallies, optimistic investors often take a leap on less proven businesses with blockbuster potential.

Consider Regeneron Pharmaceuticals REGENERON PHARMACEUTICALS INC.


REGN
-1.44%

, a biotech that posted its first year of positive earnings per share in 2012 but has gained 47% annualized in the past three years, vs. 17% for old pharma hand J&J. “High quality” can be a nice way of calling an investment boring.

But boring has its virtues. “If you’re willing to give up a little in bull markets, sticking with quality can pay off over the long term,” says Morningstar analyst David Kathman.

For example, the Leuthold Group ranks the 1,500 largest companies on a variety of quality measures, including growth and consistency of profits and sales. Since the beginning of 1986, its group of high-quality stocks has generated an annualized return of almost 13%, compared with 9.1% for lower quality. On a $10,000 initial investment, that’s the difference between $366,000 and $134,000 today.

Because reaping the rewards of quality takes patience, it’s important to understand exactly why these companies ultimately have an edge. That will help you hold on during fallow periods. And then, of course, you have to know where to find quality, whether in individual stocks or in the funds that specialize in corporate America’s seasoned winners.

Money

Why quality is poised to win right now…

The playing field is starting to look less inviting for the low-quality companies that gained the most from this bull run. The Federal Reserve’s unusual efforts since the financial crisis to create stability — from holding the key Federal funds interest rate at zero to buying up bonds—have fostered low market volatility. That has made investors less interested in paying up for historically stable and resilient companies. Rock-bottom interest rates have also made it easier for financially wobbly firms to borrow and fund growth.

But now rates are heading upward, albeit slowly. That will start to shift the advantage to companies with low debt.

Moreover, this bull market is just shy of its seventh birthday. After such a long run, market valuations — what investors are willing to pay for a stock per dollar of its earnings — are already above their historical norms, so it’s harder for sentiment alone to keep pushing shares up. Investors will need to see actual earnings. Interestingly, you don’t even have to pay a premium price to get those solid profits. In fact, high-quality stocks are slightly better priced, at 18.5 times earnings per share, compared with 20 for low-quality ones.

…And why it works in the long run too

Quality’s long-term performance edge is all about making lemonade when the market is selling lemons. The dependable profitability of quality stocks helps them lose less when stocks drop. For instance, you could see this in action last summer, when China’s economic woes sent the S&P 500 into a (temporary) spin as investors fretted about global economic growth. Leuthold’s group of high-quality stocks lost 2.8%, compared with an 8.1% decline for low-quality stocks.

If you find it difficult to stomach the inevitable bear markets that are part of investing, high-quality stocks can be a valuable antacid. “Knowing you will probably lose less in bad markets with high-quality stocks can make it easier to stay invested,” says Sam Stovall, U.S. equity strategist at S&P Capital IQ.

Now, there’s a bit of a puzzle here: In theory the only way to capture higher returns is to take more risk. So how can companies with less volatile share prices and more dependable profits actually outperform?

Look no further than the appeal of casinos and lotteries. Analysts at GMO, a global investment firm with a taste for quality, theorize that investors trying to get in on the next big thing tend to bid up the price of the lower-quality stocks that might win the lottery. That works sometimes, but on average the higher prices tend to drag down the potential for future returns vs. those of the less frothy high-quality shares.

Illustration by SHOUT

The telltale numbers that signal quality

Ready to lean against the crowd and add some quality shares to your portfolio? The investing pros who seek quality have countless methodologies for finding it, but here are the most intuitive measures that help you spot the financially strong, well-managed companies that are likely to outperform over time:

Look for a high return on equity. This is one of the most widely used quality measures. You can find return on equity (ROE) on stock research sites like Yahoo Finance and Morningstar, or grab a company’s financial statement and divide net income by shareholder equity. A consistently high ROE suggests that when a company brings a dollar in — such as when it sells its own shares or retains some profits instead of paying them out in the dividend — the managers know how to put it to good use and turn it into earnings. The average large-cap stock has an ROE of 18%. Companies with even higher scores include PepsiCo PEPSICO INC.


PEP
-0.29%

, which has 21 brands with over $1 billion in annual sales each, helping it hit a fat 28% ROE. Nike NIKE INC.


NKE
2.68%

gets 29%, thanks to a leading global market share in footwear and activewear.

ROE is a linchpin of the Jensen Quality Growth


JENSX
0%

mutual fund. Its managers consider only stocks that have delivered 15% ROE in each of the past 10 years, which is a higher bar than it looks, considering that it must be an unbroken streak. Its portfolio has an average ROE close to 30% and includes a nearly 5% stake in J&J. Over the past decade the Jensen fund has edged out the S&P 500 by an annualized 0.4%, and fell eight percentage points less than the market during the 2008 selloff.

Watch out for debt. A limitation of ROE is that managers can juice it by relying on borrowing instead of equity to grow earnings. Yet debt can eat into future profits. Low debt, on the other hand, gives a company a lot of flexibility to keep churning out earnings, even in tough periods. One key to J&J’s long track record of rising profits and dividends is a debt so low that it’s one of only three companies with an AAA credit rating from S&P. The others are Microsoft MICROSOFT CORP.


MSFT
1.75%

and Exxon Mobil EXXON MOBIL CORPORATION


XOM
0.89%

. All three stocks are top holdings of MSCI USA Quality Index (QUAL), an exchange-traded index fund. It tracks companies with both low debt and a high ROE.

Or keep it simple and look for consistency. The easiest way to get at quality is to trust in a company’s earnings track record. The PowerShares S&P 500 High Quality ETF POWERSHARES EXCHAN POWERSHARES S&P 500 QLTY PF


SPHQ
1.16%

follows S&P’s quality screens, including stocks with 10 years of earnings and dividend growth and stability. This by default catches some of the same stocks revealed by more complex quality measures. For example, the portfolio’s 26% ROE is nearly one-third higher than the benchmark S&P 500. Its straightforward approach and expenses below 0.30% a year have earned it a spot on the newest MONEY 50 list of recommended funds.

The businesses behind the statistics

Numbers aren’t everything. You can bolster the case for buying by understanding a company’s story and the special edge that helps it deliver profits year after year. Or you might even pick up on a business that doesn’t make it through the statistical screens but still has a crucial hallmark of the quality you’re looking for.

Identify the moat. Quality maven Buffett coined the idea of an economic “moat” around a company—something that allows it to defend its profitable business. That might be a strong brand name that drives demand, a hard-to-replicate delivery system, or the scale to exert pricing power on the market. “Wide-moat businesses are just the sort of all-weather companies that can continue to create value regardless of market conditions,” says Jensen Quality Growth co-manager Eric Schoenstein.

MasterCard MASTERCARD INCORPORATED


MA
-0.14%

, a new pick in Schoenstein’s portfolio, is a classic example of a wide-moat stock. It’s one of two dominant players in electronic payment systems in a world that is increasingly using credit, not cash, and it would be hard for a new company to build another rival network.

Analysts at investment research firm Morningstar assign 1,500 or so stocks a moat rating of wide, narrow, or no moat. Some funds with lots of high-moat stocks include Bridgeway Blue Chip 35 (BRLIX; 77% wide moat), Dreyfus Appreciation Investor (DGAGX; 70% wide moat), and also the Jensen fund (70% wide moat). The Market Vectors Morningstar Wide Moat ETF (MOAT) adds a value twist, holding the 20 wide-moat stocks trading at the steepest discount to Morningstar’s estimate of their fair value.

Buffett’s own holding company, Berkshire Hathaway BERKSHIRE HATHAWAY INC.


BRK.B
1.25%

, is itself an attractive wide-moat business, says Darren Pollock of Cheviot Value Management. He notes that Berkshire Hathaway owns 10 subsidiaries that would be included in the Fortune 500 if they were independent. Moreover, Berkshire’s financial strength is a big competitive advantage. It is able to finance growth with its impressive free-cash flow, along with an unusual source of cheap financing. Its insurance subsidiaries continually collect premiums and then invest some of the “float” before claims are paid.

Don’t ignore companies still in a high-growth mode. Larry Puglia, manager of MONEY 50 fund T. Rowe Price Blue Chip Growth (TRBCX), seeks out quality but allows himself some freedom. The fund’s current top holding, online retailer Amazon AMAZON.COM INC.


AMZN
0.89%

, is also the largest position in S&P’s low-quality index. S&P’s quality screen focuses on per-share earnings left over after expenses. Amazon generates a ton of money, but it also reinvests just about every penny in growing its operations, so its net earnings don’t look as sharp in S&P’s quality lens. Puglia says he cares more about Amazon’s strong revenue and its dominant market share—in short, the underlying generators of quality over time are all there.

The fund also owns large stakes in Google’s parent company, Alphabet ALPHABET INC.


GOOG
1%

, purchased when it first went public (and was still called Google), and Facebook FACEBOOK INC.


FB
-0.29%

, which the fund first owned prior to its IPO. Both would have been too young to pass many quality screens, but like Amazon they are the clear dominant players in huge new businesses. “We are not afraid to draft rookies,” says Puglia, “if we see they have a sustainable competitive advantage and we have confidence in their management.” The fund’s mix of quality and growth potential has led it to a 9.3% annualized gain over the past 10 years, nearly two percentage points better than the S&P 500.

Quality makes dividend investing better

Investors focused on grabbing income from high-dividend-yield stocks should consider a quality bias too. Dividend investing can lead you into a value trap, in which a troubled company has a high dividend yield mainly because its price is dropping. (The yield is the dividend divided by price.) Quality helps you avoid that.

Money management firm Research Affiliates looked at the 200 highest-yielding large-cap stocks each year starting in 1963. It then ranked them on profitability, debt level, and sound accounting principles. The 13.4% annualized return for the 100 stocks with the highest quality scores was two percentage points better than the lower-quality high-yielders. And the quality slice had stronger dividend growth—the holy grail of dividend investing—over the next five years.

Schwab U.S. Dividend Equity ETF (SCHD; 2.9% yield) tracks an index of 100 high-yielders that are also high quality. Stocks must have paid dividends for at least 10 years to make the cut. They are then ranked on quality screens, including ROE, debt, and the five-year growth rate for the dividend payout. Nearly three-quarters of the current portfolio is invested in stocks Morningstar deems to have wide moats.

Vanguard Dividend Growth (VDIGX; 1.8% yield) has a strong quality bias as well, with 76% of assets invested in wide-moat stocks. Over the past 10 years, in months when the S&P rose, the fund captured less than 90% of the index’s gain, meaning it slightly lagged the index in good months. But in months when stocks lost money, the fund fell just 73% as much as the index. That habit of sticking close in good markets and crushing it in bad markets propelled Vanguard Dividend Growth to a 9% annualized gain for the past 10 years, more than 1.5 percentage points ahead of the S&P 500. That’s quality anyone can appreciate.

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