It’s often said that beauty is in the eye of the beholder. For some, it’s about aesthetics and the appeal of shape and form. But for others, real beauty is found in qualities that aren’t always obvious.
In the stock market, the same subjectivity applies to company quality.
Unlike other broad investing themes, such as valuation and momentum, quality doesn’t really have a precise definition. That said, many would agree that quality is a broad measure of business strength, financial health and accounting stability.
In other words, a high quality company is one that’s very efficient at generating sustainable, exceptional profitability. Its finances are improving over time and there aren’t any accounting red flags to worry about.
At the other end of the spectrum, a low quality company is one where profitability is non-existent or intermittent. Its financial health is shaky, with debts and cash flow a concern, and the red flags of weak finances show it to be a risky investment.
With this in mind, owning shares in high quality, “beautiful” companies makes lots of sense to many investors. Indeed, it’s the signature strategy of some of the world’s most respected stock pickers.
Yet because quality can mean so many different things (and be measured in many different ways), knowing what to look for isn’t always obvious.
There are numerous financial ratios that can help. Indeed, there are entire frameworks for finding economic ‘moats’ or understanding a company’s competitive environment - and these can be very useful ways of finding out just how good a company is.
But day-to-day, any investor with even half an eye on financial strength (and whether it’s good or bad), needs a go-to checklist to see where the strengths and weaknesses are.
A quality checklist can be a useful part of any investment strategy. It can be particularly useful in trying to understand potential mispricings and where the market is unfairly marking down the prices of quality stocks that have, for some reason, fallen out of favour.
Why quality checks can improve any strategy
Buying high quality stocks is a tried and trusted approach to the stock market. Warren Buffett, the billionaire legend of company investing, forged a long and formidable reputation for profiting handsomely from owning what he describes as “wonderful” businesses.
From an academic standpoint, research in this area has accelerated in recent years. So much so that quality is now a…
