{"id":25681,"date":"2022-12-22T16:18:40","date_gmt":"2022-12-22T21:18:40","guid":{"rendered":"https:\/\/einvestingforbeginners.com\/?p=25681"},"modified":"2023-11-10T08:56:56","modified_gmt":"2023-11-10T13:56:56","slug":"what-are-quality-stocks","status":"publish","type":"post","link":"https:\/\/einvestingforbeginners.com\/what-are-quality-stocks\/","title":{"rendered":"What are Quality Stocks? Do They Outperform? What are the Pitfalls?"},"content":{"rendered":"\n
Updated – 11\/3\/23<\/em><\/p>\n\n\n\n Quality stocks are a popular type of stock market factor. Quality stocks are generally defined as businesses with above average growth and lower risk (of bankruptcy).<\/p>\n\n\n\n Based on these definitions, it would sound that quality stocks are always the best ones to own.<\/p>\n\n\n\n But that is not always true.<\/p>\n\n\n\n As with everything in the stock market, factors go in-and-out of favor. While ideally, we\u2019d all hold high quality businesses forever\u2014the reality is sometimes different. The price you pay matters.<\/p>\n\n\n\n To examine what quality stocks are and when to buy them, this post will cover:<\/p>\n\n\n\n Let\u2019s start with the basics.<\/p>\n\n\n\n <\/p>\n\n\n\n A share of stock is a part-ownership stake in a business. It is not a piece of paper resembling a lottery ticket, though sometimes it can seem (and be) that way.<\/p>\n\n\n\n The stock market is simply a place to buy and sell these ownership stakes.<\/p>\n\n\n\n Though the stock market is flashy and can seem like a casino, it really is a place to become part-owner of some of the biggest businesses in the world. As these businesses grow and increase their value, the prices of their shares will generally also increase, over the long term.<\/p>\n\n\n\n The logic says, then: find the best businesses, and your shares will increase the greatest, over the long term.<\/p>\n\n\n\n\n\n\n\n Some of the best investors of all-time have taken that approach, including billionaire Warren Buffett. As Buffett is popularly quoted:<\/p>\n\n\n\n \u201cIt\u2019s far better to pay a fair price for a wonderful business, than a wonderful price for a fair business.\u201d<\/em><\/p>\n\n\n\n \u2014Warren Buffett<\/p>\n\n\n\n But don\u2019t lose the inclusion of price here.<\/p>\n\n\n\n Some of the greatest businesses of all-time have been terrible investments, at one point or another. Shares of stock represent businesses, but sometimes these shares can trade at wide gaps between what they are actually worth.<\/p>\n\n\n\n This is because the stock market is an emotional place.<\/p>\n\n\n\n This market, also referred to as Mr. Market<\/a><\/strong> by Buffett and others, is greedy and fearful.<\/p>\n\n\n\n This means\u2026<\/p>\n\n\n\n You can buy quality stocks and beat the market over the long term. But you can buy quality stocks and still underperform the market.<\/p>\n\n\n\n Like many things with investing, and life, it\u2019s about balance.<\/p>\n\n\n\n <\/p>\n\n\n\n We can look to some popular stock market ETFs for insight on how investors define \u201cquality\u201d today.<\/p>\n\n\n\n One of the most popular is the iShares MSCI USA Quality Factor ETF, ticker $QUAL.<\/p>\n\n\n\n This is an ETF by BlackRock, the largest asset manager in the world<\/strong>. $QUAL holds some of the best businesses out there today, which include companies like (as of November 3, 2023):<\/p>\n\n\n\n Right now the portfolio has 127 stocks and a trailing yield of 1.36% (from dividends). It focuses on large cap and mid cap stocks (bigger companies). <\/p>\n\n\n\n Something I found interesting is that since first writing this post in 2022, and updating it in 2023, Home Depot had fallen off the list. It makes you wonder, is Home Depot no longer a quality company?<\/p>\n\n\n\n To answer this question and more, we first have to answer,<\/p>\n\n\n\n How does BlackRock decide which stocks to include in their ETF?<\/p>\n\n\n\n The following three fundamental qualities hold heavy weighting in the decision to include a stock in this list or not:<\/p>\n\n\n\n Each of these qualities deserve a blog post of their own, which we\u2019ve written about on this site already (Return on Equity<\/a><\/strong>, Earnings Growth<\/a><\/strong>, Financial Leverage<\/a><\/strong>).<\/p>\n\n\n\n But at its most basic form, let\u2019s discuss each of these, and why they indicate \u201cquality.\u201d<\/p>\n\n\n\n The return on equity metric compares a company\u2019s balance sheet and income statement. It essentially measures how much profit a company gets from its investments.<\/p>\n\n\n\n The formula for Return on Equity, or \u201cROE\u201d, is:<\/p>\n\n\n\n ROE = Net Income \/ Shareholder\u2019s Equity<\/strong><\/p>\n\n\n\n Net income is a company\u2019s profits. Shareholder\u2019s Equity, also sometimes called Book Value, is the difference between a company\u2019s Total Assets and Total Liabilities. It is Assets minus Liabilities.<\/p>\n\n\n\n The higher a company\u2019s ROE, in general, the less assets it needs to create profits.<\/p>\n\n\n\n This can indicate quality because the less assets a business needs to grow, in general, the faster and easier it can grow.<\/p>\n\n\n\n
Introduction to Quality Stocks<\/h2>\n\n\n\n
What\u2019s a Quality Stock?<\/h2>\n\n\n\n
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1\u2014High Return on Equity<\/h3>\n\n\n\n