Hazelle
in Memos & Musings · 4 min read
2 years back, the U.S. stock market was rallying up to all time highs. High growth stocks took the spotlight and it was easy to make money from them even if the business is still loss-making, burning lots of cash and has a narrow moat.
But that did not last for long. Fast forward to the present, many of these unprofitable, high growth stocks had their stock prices slammed and they were struggling to cut costs and stay afloat. The investor’s dream of seeing some of these high growth stocks turned into the next Amazon or Google was crushed.
Most investors are familiar with growth investing but few are acquainted with quality investing. The key to enhancing your long-term investment returns sustainably is to pick quality stocks to invest in.
What are quality stocks/businesses?
Quality stocks are simply businesses which have a good track record of earning higher profits (as opposed to plans to become profitable in the future), generating more organic cash inflow to be reinvested back into the business, minimal solvency risks and have a relatively unbreachable economic moat.
Why is investing in quality stocks important for good investment returns?
Quality businesses that have relatively wide economic moats are able to fend off competition, maintain their market share and stable customer base. The economic moats also give rise to pricing power, allowing them to pass on higher costs to their customers and protect their profit margins. Take a look at Starbucks for example. Despite raising the prices of their coffee, it isn’t stopping consumers from spending at Starbucks and revenue continues to grow.
As a result, these businesses tend to deliver relatively stable revenue and lower earnings volatilities even during economic downturns, as compared to the young, high growth companies.
In addition, quality businesses tend to have more robust balance sheets and solid cash reserves to position themselves to withstand the economic downturns.
As Benjamin Graham says, “In the short run, the stock market is a voting machine, but in the long run, it is a weighing machine.” No doubt in the short term there may be some selloff in the stock market due to irrationality and emotions, but the durable long-term profitability of these quality businesses will eventually translate into long term stock price appreciation. Share prices are ultimately driven by earnings over the long run.
Quality outperforms the overall market historically
Historically, it has also been shown that quality stocks tend to outperform the overall broad market. For the purpose of comparison, we will use the MSCI US Quality Index to represent performance of quality growth stocks and the MSCI US Index to represent the overall broad market.
Over the last 10 years, the trailing 12-month EPS growth for MSCI US Quality Index tends to experience a smaller decline compared to MSCI US Index during the key market declines.
For instance, during the Covid crash in 2020 and the current inflationary period, the MSCI US Index which represents the broader market, experienced a steeper decline in EPS growth.
Correspondingly, the index also underwent a greater maximum drawdown during the market crashes in history.
And if we compare the long term performance of the S&P 500 index against names like Google, Nike, Mastercard and Costco, these quality stocks generally outperform the S&P 500 over the long run.
The reason is that though companies have to pass certain minimum criteria to be added to the S&P 500 index, not all 500 of the companies are considered quality businesses for investment purposes. One of the key criteria to be added to the S&P 500 index is simply to report positive earnings for the most recent quarter and for the last 4 quarters combined, which frankly, is not a high benchmark. Quality businesses exhibit not just positive earnings for the last few quarters, but increasing earnings for the past few years.
Challenging macro environment
The current challenging macro environment where we are facing high inflation and rising interest rates would put more pressure on the revenue and earnings of businesses. The good news is that upon analyzing the past recessions, the EPS of quality businesses tend to hold up much better than the overall market. These are times when having quality stocks in your portfolio will reduce the overall investment portfolio risk and boost your overall long-term investment returns.
In the short term, stock prices of quality stocks can still decline during an economic downturn due to negative sentiments and irrationality. But eventually these businesses will emerge stronger and this will be reflected in the stock prices where prices rebound faster and greater than the broad market.
Concluding thoughts
The ability to pick quality stocks to invest in is an edge that an investor should develop in their investing journey. Most stocks do not perform well over time and bad ones can result in a huge dent in your portfolio returns.
Quality stocks are usually more resilient in down markets and outperform over the long run due to the durability of their profits, stable revenue and cash flows and robust balance sheets. While quality stocks are not immune to market drawdowns, they have a greater chance of recovering due to their strong fundamentals and ability to generate earnings and cash. On the other hand, many of the unprofitable businesses may not be able to recover after an economic downturn.
By picking quality stocks to invest in, it lowers our investing risk where we put our money into our “best bets” and increases the probabilities of our investment success. Over the long term, it enhances our investment returns where quality stocks tend to outperform the broad market. It also gives investors the conviction to stay on with their investments regardless of the market conditions. In the short term, quality stocks aren’t immune to market drawdowns, but they are important in helping investors to create an infallible portfolio that will likely see new highs when the sun is out again.
About Hazelle
Chief trainer of The Moneyball Investors Playbook program and founder of The Joyful Investors, a financial education firm that seeks to help avid investors learn to invest better and make the journey a joyful one. I graduated with a first class honors in Bachelor of Accountancy from Nanyang Technological University (NTU) and started my auditing career in one of the Big Four. I believe that once we know how to build our wealth sustainably, we can then live our best lives ever.
Important Information
This document is for information only and does not constitute an offer or solicitation nor be construed as a recommendation to buy or sell any of the investments mentioned. Neither The Joyful Investors Pte. Ltd. (“The Joyful Investors”) nor any of its officers or employees accepts any liability whatsoever for any loss arising from any use of this publication or its contents. The views expressed are solely the opinions of the author as of the date of this document and are subject to change based on market and other conditions.
The information provided regarding any individual securities is not intended to be used to form any basis upon which an investment decision is to be made. The information contained in this document, including any data, projections and underlying assumptions are based upon certain assumptions and analysis of information available as at the date of this document and reflects prevailing conditions, all of which are accordingly subject to change at any time without notice and The Joyful Investors is under no obligation to notify you of any of these changes.
· · ·
Have you enjoyed this article? We’d be grateful if you would share this useful content to your friends who may benefit from it as well.
