What is quality investing?

Investors are always on the lookout for stocks, exchange traded funds (ETFs), or mutual funds that demonstrate strong performance and reliability. One way to evaluate potential investments is by identifying companies with quality characteristics. Like shopping for a trusted, long-lasting brand, quality investing focuses on selecting stocks that demonstrate reliable and resilient long-term returns.

"When it comes to stocks, quality companies are robust and stable," points out Chadi Sayeh, Director, Manager Monitoring at National Bank Investments. "These are companies that have deep foundations and can weather market ups and downs, as well as shifting economic conditions."

This approach focuses on assets associated with long-term growth and stability, offering insights for self-directed investors exploring the market.

What is quality investing?

Quality investing is a type of factor investing, sometimes referred to as quality factor investing. Factor investing is an umbrella term for an approach that uses specific characteristics, such as value, size, momentum, volatility, or quality, to evaluate and drive investment decisions.1

As the name suggests, quality investing prioritizes companies and assets with strong fundamentals, rather than focusing on undervalued or inexpensive stocks.  It aims to identify companies with strong financial health and potential for long-term growth.2  

This approach is based on the principle that certain companies consistently outperform their peers and as a result have a competitive advantage. These companies excel in their operations, efficiently manage their capital, and demonstrate strong financial health. This translates into a financially healthy company with earnings that are consistently growing quarter after quarter, year after year, and so on. Typically, quality companies exhibit steady profit growth, supported by consistent cash flow, a strong balance sheet, and low debt levels.

How do investors measure quality?

Measuring quality often involves evaluating both quantitative financial metrics and qualitative aspects of a company’s management. To establish quality, investors look at balance sheet numbers to evaluate business performance and human factors linked to managing the company. 

Quantitative, number-based metrics commonly used to establish quality include:1 

• Consistent year-on-year asset growth 
• Low debt-to-earnings ratios
• Stable earnings

Qualitative considerations focus on the effectiveness of a company’s leadership. Strong and effective management plays a critical role in maintaining a company’s competitive advantage. Effective leaders make informed decisions and proactively address challenges to steer their companies through market complexities.

Over time, companies that have demonstrated the ability to weather economic downturns and market volatility, maintain low debt, achieve profitability, and exhibit strong management often develop a reputation as 'quality' investments. Consequently, investors will assign these businesses more value and a higher share price. 

What are the advantages and disadvantages of quality investing?

Like any investment strategy, quality investing has both pros and cons.  

Some of the advantages of quality investing include:

• Reduced risk - Since quality companies have a proven track record of success, there is a lower probability of financial loss over the long term.
• Lower volatility -  Quality securities, like low volatility stocks, tend to exhibit less dramatic price fluctuations. These assets often hold up better during market downturns, which may appeal to those with a lower tolerance for volatility.
• Dividends – Many quality securities pay dividends, providing shareholders with regular payouts. Similar to dividend paying securities, these investments will distribute excess cash flow to stock holders through quarterly or semi-annual payments.

Some of the disadvantages of quality investing include:

• Long-term approach - Quality investing is generally more suited to those with long-term investment goals, as securities with higher risk and volatility can outperform quality stocks in the short term.
• Limits diversification - Focusing primarily on well-established, quality companies can limit the range of potential investments, making diversification more complicated. Certain sectors of the market tend to be overrepresented, while others have little to no weighting.
• Excludes growth companies -  By emphasizing established companies, quality investing might overlook opportunities in speculative companies or companies that fall into the growth investing category that could offer higher returns. 

How to use quantitative factors to evaluate quality stocks

Evaluating quality stocks often involves analyzing a company’s financial metrics to identify those with strong fundamentals and competitive advantages. A quantitative evaluation typically includes two key steps:

1. Comparing a company's financial ratios to industry averages. 
2. Assessing the consistency and year-over-year improvement of these ratios, while avoiding those that show significant volatility or fluctuations.

Below are some commonly used financial ratios for evaluating the performance of a quality stock or company:

• Return on Equity (ROE) - ROE is calculated by dividing a company's net income by its shareholder equity. This ratio measures how efficiently a company uses its equity to generate profits.3 A higher ROE is preferable to a lower one, and an ROE that improves year-over-year is considered a positive indicator.
• Earnings per Share (EPS) - EPS measures the profit generated per share and is determined by dividing a company's net income by the total number of outstanding shares. The higher the EPS, the more profitable the company. A positive and growing EPS would be a good indicator of a quality stock. 
• Debt to Equity (D/E) Ratio – The D/E ratio measures the extent to which a company relies on debt compared to shareholder equity for financing its operations. While a lower ratio is generally preferred, it is important to compare companies within the same industry and observe trends over time. A decreasing D/E ratio can indicate a company is reducing its reliance on debt.

How can I invest in quality stocks?

For self-directed investors, there are various ways to invest in quality stocks, depending on preferences and investment goals. Mutual funds and ETFs offer quality themed investment solutions for those who prefer not to buy individual securities. These funds typically have the word 'quality' in their name, making it easier to identify them. NBDB clients can use our ETF Centre and consult the Exchange Traded Funds Report to find potential candidates.

DoeIf you are considering specific stocks or ETFs, it’s essential to evaluate them based on quality factors. Trading Central’s Fundamental Insight tool, available in the quote section of our online brokerage platform, can analyze your stock pick and provide a rating based on quality investment characteristics.

Quality investing is one of many investment strategies that investors can pursue. It may be a suitable approach to consider for self-directed investors seeking stable returns over an extended period. As National Bank Investment’s Chadi Sayeh highlights, "Even if you decide to take a more aggressive approach and are comfortable with more volatility and risk, a well-rounded portfolio will typically include some quality stocks."

It is crucial for both new and experienced self-directed investors to remember that every investment carries some level of risk, including a quality-based strategy. Choosing high-quality securities does not eliminate risk. Staying informed and monitoring evolving market conditions and global events is essential. Conduct thorough research, make well-informed decisions, and consider how various investments align with your financial objectives.

Further reading

Here are some articles and tools available on the NBDB website that you can consult to learn more and guide you on your self-directed investing journey:

• How to start investing: A guide for beginners
• What is an ETF: Everything you need to know
• Trading Central