When stock markets are volatile, many investors turn to high-quality stocks. What are they, and how might they be used in your portfolio? High-quality stocks are stocks of companies with outstanding characteristics based on a set of clearly defined criteria, such as balance-sheet strength and good management.
Because finding a high-quality stock among the thousands that trade on exchanges can be a daunting undertaking, high-quality investors often focus on certain criteria. These criteria may include return on equity (ROE), return on assets (ROA), and return on capital employed (ROCE).
As complicated as these criteria sound, they essentially speak to a company’s ability to generate earnings from its investments. ROE indicates how much profit a company has earned relative to shareholder capital. ROA indicates how efficient a company’s management is at using assets to generate earnings. Finally, ROCE indicates how efficiently a company is using its capital investments, which include all long-term funds used by the company. An increase in these three measures suggests that a company is growing.
That said, these measures may not be the only indicators of a company’s prospects. Other criteria – such as growth of the industry in which a company operates – can also affect a stock’s performance, and thus merit close scrutiny.
How important is quality in a stock? Very. Benjamin Graham, who is often called the founding father of value investing, has said that the greatest investment losses result not from buying high-quality stocks at high prices, but from buying low-quality stocks at low prices.