The Quality Factor: Find Stocks That Weather the Worst Markets

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You might have heard Warren Buffett’s quote: “Price is what you pay. Value is what you get.”

Investors can be enticed to buy “penny” stocks because they think the stock could easily rise by 5, 10, 100 or more.

But here’s the cold, hard truth, folks.

It doesn’t matter whether you pay $20, $2, or 20 cents for a stock if the stock is complete junk.

Look, Buffett’s success didn’t come from simply paying the cheapest price for any stock. It came from buying quality stocks for less than they were worth.

While Buffett’s always been called a “value investor,” he’s equally a “quality investor.”

We’ve covered four of the six factors in my Green Zone Ratings system in recent weeks:

The Quality factor is interesting to me because, arguably more than any of the other factors, it seems so obvious!

Isn’t it intuitive that you’re better off buying a profitable company than an unprofitable one — a high-quality company over one of poor quality?

But as an investor, you need to understand the Quality factor so that you understand what you’re getting when you buy a particular stock.

How We Quantify “Quality”

I should clear up one thing first…

The Quality factor is about more than just profitability.

Of course, profitability drives the Quality factor. My Green Zone Ratings system considers a company’s profitability from a number of perspectives, including return on assets, return on equity and return on invested capital, over short- and long-term time frames.

It also factors in a company’s profit margins, including the gross profit margin, net profit margin and free cash flow margin.

Finally, in terms of profitability, my model considers earnings, operating cash flow and free cash flow on a per share basis … as well as the consistency of earnings over prior quarters.

Beyond profitability, the Green Zone Quality rating also includes information about a company’s debt load and its ability to service that debt. And it looks at a metric called asset turnover, which measures the efficiency of a company’s operations.

All told, the Quality factor is built on 27 individual metrics.

It’s an effective way to help us distinguish high-quality companies worth considering from the “junk” that, at any price, we should leave alone.

As far as why the Quality factor works…

It All Comes Down to Expectations

All the academic literature supporting market-beating factors seeks to “explain” the factors with one of two general frameworks.

These are:

  1. A risk-based explanation — The factor “works” because stocks that possess it are inherently riskier than other stocks. Thus, they must provide investors a premium to compensate for that extra risk.
  2. A behavioral-based explanation — The behavioral biases that are baked into human nature lead to stocks becoming “mispriced,” thus allowing factor investors to buy the underpriced stocks and avoid (or short) the overpriced ones.

As you may suspect, quality stocks are generally not riskier than poor-quality stocks. Not only does that make sense intuitively … but it’s also proven in the real world.

A number of studies have shown that the outperformance of “quality” stocks over “junk” stocks is even more pronounced during recessions and bear markets!

So behavioral reasons primarily drive the Quality factor.

Essentially, investors routinely expect mean-reversion:

  • We expect companies of poor quality and low (or negative) profitability to improve ahead.
  • And we expect companies of high quality and high profitability to do less well ahead.

But in reality — much like the Green Zone Momentum factor shows us — more often, “winners keep winning, and losers keep losing.”

So, when investors expect favorable “turnarounds” from poor-quality companies, they’re being foolishly optimistic … which leads to these stocks being overvalued.

And when we expect “give back” from high-quality companies, we’re being unnecessarily pessimistic … leading to these stocks being undervalued.

That’s why you can earn market-beating returns if you simply buy “high-quality” companies: Chances are, you can buy these stocks for less than they’re worth and enjoy all the benefits you get when you buy something of quality!

A Final Note on Quality

Interestingly, many stocks that earn high Green Zone Quality ratings are stocks that we think of as “growth” stocks, as opposed to “value” stocks.

And the perception is typically that growth stocks are “expensive.”

The Green Zone Quality factor doesn’t always point us to “expensive” stocks, per se. But when a “quality” stock has a richer valuation than a “value” stock, it’s often the case that it’s worth a higher valuation because it’s a better company, one which will produce stronger returns in the future.

Here’s the best part: You don’t have to choose between “value” and “growth,” or between “value” and “quality.” These aren’t clear-cut, binary decisions.

Research Analyst Matt Clark, my colleague, recently discussed a stock on The Bull & The Bear podcast that my Green Zone model rates a perfect 100 on Value, 98 on Quality, 95 on Momentum … and a 98 overall!

Watch the video to learn more now:

Buffett looks for the perfect balance between quality and value.

He also looks for the “potential for continued growth.”

You probably don’t think of Buffett as a “growth investor.” But even this “value” guy understands the potency of a quality company, trading for a great price, that’s also growing!

Later this week, I’ll talk about Growth, which will round out my breakdown of the six major factors that drive the performance of my Green Zone Ratings model for stocks.

And keep an eye out! My team and I are releasing a book in the coming days. It will show you how you can use my favorite factor, Momentum, to become a millionaire when you “buy high, and sell higher.”

Momentum drives every investing decision I make. I know you’re going to be blown away when you find out how powerful it can be — and how easy it is to follow!

If you have any questions about the factors we’ve covered so far, don’t hesitate to reach out!

Please send questions or comments you’d like my team and me to address to feedback@moneyandmarkets.com.

To good profits,

Adam O’Dell, CMT

Chief Investment Strategist, Money & Markets

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