Quality is easy to fake. That’s why poor performers get hired and bad used cars get sold. Investing is no exception. With a quality approach, traders go long on winning stocks using predefined qualitative and quantitative criteria.
Quality investing is a portfolio strategy that identifies companies with outstanding prospects based on criteria in matters of management practices, business model, and financial statements. It is distinct from growth investing, which emphasizes price trends, and from value investing, which relies solely on financial metrics.
But what are its success rates? Who decides what criteria to consider? What tools does it require?
Most importantly, should you do it?
Brief Background
Dynamic markets started with the NYSE, which grew from a measly 300 stocks in 1865 to 1 million in volume by 1886, or 20 years. Quick growth supported speculation and just 40 years after that, the NYSE had enough weight to start the great depression.
After the 1929 crash, Benjamin Graham began exploring ways to invest using analytics, rather than gut feeling like you would haggling at a fish market. He therefore fathered value investing, a stock picking strategy based on financial statement criteria such as 2-to-1 working capital, positive cash flows, and Price-to-Earning ratio less than 25, and a Trailing-Three-Months price evolution of -30%. Another 40 years later, economics took off.
In 1970, economist Milton Friedman published the Friedman Doctrine, an essay arguing a company’s purpose is solely to increase shareholder value. This work spurred a revolution in management practices capable of systematically increasing shareholder value, dubbed “value-based management.”
Together, value investing and value-based management produced quality investing.
Definition
A very thorough definition of quality investing is as follows.1
Quality investing (noun): a risk-averse long-position stock strategy that focuses on identifying companies with outstanding sustainable competitive advantages by evaluating their coherence to rigorous criteria in
- strategic management–including minimal publicity, independent incentives, long tenure, and tenacious testing;
- financial metrics–including capital allocation to growth efforts and return on capital; and
- business fundamentals–including barriers to entry and competitive landscape.
Stocks are the Vehicle of Quality Investing
Because quality investing focuses on criteria related to businesses, it’s NOT a strategy for other securities like currencies (FX), commodities, non-corporate bonds, or annuities. Stocks alone are the vehicle of quality investing.
Criteria: Selection and Categories
Quality criteria must be predefined to avoid human bias, but each investor chooses her own criteria and adjusts over time. This freedom differs from value investing, which defines quasi-permanent universal metrics.
Investors have developed “factor” investment strategies that combine quality criteria with price-trend styles such as momentum and volatility. They refine quality criteria to harmonize with other factors. The MSCI Quality index, Fama-French, and F-score are examples, although each of these uses only financial criteria and ignores qualitative metrics.
Northern Trust takes it a step further and chooses “criteria that risk-averse investors typically want,” such as converting assets into sales and remaining solvent. This is a qualitative approach.
Criteria by Investors, for Investors
Every investor has the freedom to copy and invent criteria. There are no fixed rules. It can seem chaotic, but all criteria fall into 3 categories: business fundamentals, financial metrics, or strategic management. This table provides a comprehensive list of the possibilities.
| Criteria Level 1 | Criteria Level 2 | Criteria Level 3 |
|---|---|---|
| Business Fundamentals | Business Model | |
| Competitive Advantage | ||
| Customer Benefits | ||
| Industry Structure | ||
| Market Positioning | ||
| Network Effects | ||
| Technology | ||
| Financial Metrics | Asset Turns | |
| Capital Allocation | ||
| Debt to Equity Ratio | ||
| Ratio of Gross Profits to Assets | ||
| Return on Capital | ||
| Strategic Management | Growth Opportunities | Gaining Market Share |
| Geographic Expansion | ||
| M&A | ||
| Multiple Sources of Growth | ||
| R&D | ||
| Working Capital | ||
| Management Quality | Discipline | |
| Independent | ||
| Long-term | ||
| Out of the Limelight | ||
| Tenacious |
As you can see, criteria and qualitative and quantitative, precise and ambiguous, internal and external, and people or company focused. The options and combinations are vast. The wide parameters of choice is central to quality trading.
Quality Investing vs Value Investing
Quality investing and value investing differ in three ways.
- Quality criteria can be non-financial. Value investing uses ratios and metrics derived solely from a company’s financial statements (and T3M price change, but nothing else from trends).
- Quality criteria can evolve over time. Value investing criteria today are the same as what Benjamin Graham wrote nearly 100 years ago. Investors may not use all of them, but they choose and stick with them. The strategy doesn’t make sense otherwise.
- Quality investing cannot identify precise buy/sell points. Value investing suggests precise trade criteria based on predetermined calculations, whereas quality investing is simply a selector.
The value approach relies on rigid standards for all, whereas the quality approach allows for customization.
Sample Strategy
A sample quality strategy consists of 4 steps.
- Select 3 to 7 quality criteria from the list above.
- Determine criteria numerically.
- Define an appropriate time frame, usually 1, 3, 5 or all years.
- Research and Create a Portfolio.
- Backtest.
- Refine.
#1 Select Criteria
For example, let’s imagine you choose Competitive Advantage, Debt-to-Equity Ratio, and Working Capital.
#2 Determine Criteria Numerically
Let’s imagine you decide on the following:
- Debt-to-Equity: <1.5
- Working Capital: <=2
Naturally, you will weed out certain industries. Grocery stores, for example, have a business model with almost 0 receivables and high payables because customers pay immediately. That doens’t make it a bad business model, but it won’t meet your working capital criteria.
Now there’s the question of Competitive Advantage. It’s heavily dependent on industry and requires creativity and judgement to quantify. As an example, let’s take CarParts.com.
Every company has to provide investors with a list of major competitors, as well as a description of their unique competitive edge, in their annual filings. Here’s the snippet from CarParts.com’s 2022 financial year report:
CarParts.com mentions 9 competitors, none of which are direct (online selling in car niche only), so we assume there’s a least one direct competitor in point number 3.
It also lists 7 competitive features, only 1 of which unique to their business. A simple way to quantify Competitive Advantage is a ratio of direct competitors to total, and unique advantages to total. In this case it would be [-1 * [1/9]] + [1/7] = –0.03. Competition is negative because it hurts the business and competitive features is positive because it helps.
You may decide this is your reference score. Keep in mind that in addition to finding stocks, it’s recommended to incorporate them within a broader asset allocation strategy. To be clear, this example is for educational purposes so I keep it simple and a more thorough competitive analysis could be done.
#3 Define a Time Frame
The law of large numbers suggests more data produces more accurate results. This means 5 years of data is more reliable than 3, which is more reliable than 1, etcetera. To play it dangerous for our hypothetical scenario, let’s use 1 year.
#4 Research and Create a Portfolio
Now we need to use a stock screener or app to identify stocks that meet our criteria. Debt-to-Equity and Working Capital are easy to find, so we can start by performing an initial search. Then we have to search those results to calculate Competitive Advantage.
One example meeting the criteria is Alcoa Corporation, with a Competitive Advantage score of +0.02.
#5 Backtest
Now you need to see how your picks performed during the 1 year period compared to a benchmark Let’s use an S&P 500 tracker ETF. Here’s one year performance:
Our simple quality investing strategy backtests well and we beat the market.
#6 Refine
Now we to repeat steps 4 and 5 for 100s of other stocks to see how well they do. Then, and only then, can we decide whether we were successful. To help keep track of your picks over time, consider a portfolio management tool. At the very least it acts as a backup to your broker app.
Example Stocks
The fastest way to find stocks chosen for quality factors is to examine holdings in Quality Factor ETFs. Here’s a table of heavy weight stocks in popular quality factor ETFs:
| Stock | ETF Held In |
|---|---|
| Home Depot | iShares MSCI USA |
| Microsoft | iShares MSCI USA |
| Meta | iShares MSCI USA |
| Amazon | Nuveen Growth Opportunities ETF |
| Alphabet | Nuveen Growth Opportunities ETF |
| Apple | Nuveen Growth Opportunities ETF |
| Procter & Gamble | FlexShares Quality Dividend Index Fund |
| Broadcom Inc. | FlexShares Quality Dividend Index Fund |
| NVIDIA | JPMorgan U.S. Quality Factor ETF |
| VISA | JPMorgan U.S. Quality Factor ETF |
| Berkshire Hathaway | JPMorgan U.S. Quality Factor ETF |
| Exxon Mobil | JPMorgan U.S. Quality Factor ETF |
