There are various kinds of investment strategies followed by different investors. Each strategy is underlined by the same principle of earning returns on the stocks invested in. One such strategy is quality investing. Here, only those securities the show above-average quality characteristics are chosen for investment. Although the basic principle of quality investment originates from the real estate world, it applies very well to the stock market too. In share trading, fundamentals analysis and active stock picking are used as strategies to identify quality stocks. Quality investors only chose those securities that are « attractively valued. »
Quality investment is quite independent and different from other types of investment strategies such as growth investing and value investing. In growth investing, investors choose stocks of those companies that show the signs of having an above-average growth. These stocks are characterized by high price-to-earning (P/E) or price-to-book ratios. However, only these high growth factors will not attract a quality investor. A stock’s high earnings growth should also be characterized by good fundamentals of the company invested in for its price to be justified by a quality investor.
In value investing, an investor picks a stock that is believed to be trading at less than its intrinsic value or is undervalued. The stocks ideal for value investing are characterized by low P/E ratio, low price-to-sales ratio, low price to cash flow, low price-to-book ratio, and high dividend yield. In contrast, a quality investor will never buy a company’s stock just because it is undervalued. Such an investor looks for stocks that are of an excellent company and is also attractively valued.
Benjamin Graham, who is also known as the « father » of value investing, recognized the value of quality stocks.
He observed that losses resulting from stock market trading were not more due to buying quality at an excessively high price, but more from buying low-quality stocks at a price that seems good value. Hence, the importance of quality investment was recognized. Quality Investing gained prominence after the stock market « bubble burst » of 2001 characterized by bankruptcy, balance sheet manipulation, and other financial frauds. This cautioned the investors to go for targeted selection of quality stocks.
There are several criteria that can help an investor to select quality stocks:
Financial condition of a company:
Financial condition can be gauged by examining a company’s balance sheet, earnings, cash flow, free cash flow, debt, income stream, etc. The more income a company can generate with its core business, the better is its quality. Also, when reviewed in comparison with other peers in the same sector, the quality of the stocks can be well judged.
A company is believed to be as good as the quality of the people who run the company. Low turnover rates, stability in the management system, and more can speak volumes about the quality of the stocks of a particular company.
Price potential of the stock:
In quality investing, quality and attractive valuation are linked. Quality helps to prevent share price losses in bearish market conditions and attractive valuation ensures that the stocks outperform the market. Factors such as discounted cash flow, price/earning ratio, and price/book ratio in caparison to the market averages gives the investor a measure of the stock’s quality.
A company’s business model is also a good indicator of the quality of its stocks. Factors such as competitive advantage, diversification, and business trends give an estimate of the business model’s earnings potential.
The potential size of the market and the company’s position within it gives a correct evaluation of the quality of a stock.