Today, you may find yourself applying a lot of guesswork to your investments…

No one knows how the recovery in stocks and the economy will play out. But we can still make a reasonable decision about what to do next… based on the information we do have.

In short, right now, we need to buy high-quality businesses.

If you roll your eyes at this “deep” insight, we don’t blame you… Of course, we don’t want to own bad businesses. But it’s not always the obvious choice.

For one thing, plenty of people make serious money as deep value investors. They find companies priced for death and earn profits when they limp along.

For another, buying speculative assets dirt-cheap has a lot of appeal right now.

When fears subside, those risky assets tend to rally the fastest. That makes this an attractive way to invest – if you could time the bottom perfectly.

However, if you define quality specifically – not as a soft, vague description like “good businesses with strong profits,” but as an actual number you can look up – we can prove that buying quality does indeed work.

Today, quality stocks will earn us fair enough returns if the market rises… And they’ll hold their value better than other risky assets if the decline worsens.

We simply need a way to measure this idea. Let me explain…

In many ways, “value investing” is the opposite of “quality investing.” But the most famous value investor in the world understands that quality comes first. As Warren Buffett wrote in his 2012 annual letter to Berkshire Hathaway shareholders…

More than 50 years ago, Charlie [Munger – Buffett’s longtime partner] told me it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price.

Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain-hunting, with results ranging from tolerable to terrible.

In the markets, you get what you pay for. Quality businesses tend to trade for higher prices. Markets are not perfectly efficient – but you generally pay more for a profitable business than you do for an unprofitable one.

Which wins out? Over the long term, does quality justify its higher price?

If you make rules for defining quality, you can then test the candidates. Measurements of quality differ, so we’ll start with a simple one…

University of Rochester business professor Robert Novy-Marx proposes “gross profitability” as a way to measure quality. It’s simply gross profits (revenue minus cost of goods) divided by the assets of a firm.

His research finds that a portfolio that buys the highest gross-profitability stocks while shorting the lowest will earn an annual return 2.7% above the market. (That’s a significant difference in financial markets.)

Gross profit is an easy, simple-to-find number. It normally appears as the third entry on the income statement. You can check it in a few seconds… making it a great number for everyday investors to rely on.

You can also look up (or calculate) a company’s F-Score, proposed by Stanford accounting professor Joseph Piotroski.

The F-Score includes nine tests. The company gets a point for every test it passes… So companies with a score of nine have perfect quality. You can find the F-Score test formulas online, but put in plain English, these are what they determine:

  • Is return on assets positive?
  • Is operating cash flow positive?
  • Did return on assets improve in the last year?
  • Is cash flow production better than earnings?
  • Did leverage decrease in the past year?
  • Did the current ratio of assets to liabilities improve in the past year (i.e., is there more cash on hand)?
  • Did the company refrain from issuing shares?
  • Did gross margin rise in the past year?
  • Did asset turnover rise in the last year?

Asking these questions can help you beat the market. From 1974 through 2014, an F-Score portfolio returned 12.6% compared with 11.2% for the S&P 500… And it had lower volatility.

Finally, billionaire quantitative investor Cliff Asness tested the same concept in a paper called “Quality Minus Junk.” The paper uses a more complicated measure of quality, making it hard to replicate. But it proves the strength of this idea.

Looking at the ongoing returns for the “Quality Minus Junk” measure, we can see the difference in performance between quality and the S&P 500…

Quality has seen huge outperformance over the past 20 years. And for what it’s worth, while stocks as a whole fell 8% in February (according to Asness’ firm), the quality portfolio fell only 0.74%.

This proves one thing… Quality works. You should “buy wonderful companies at a fair price, rather than fair companies at a wonderful price.”

You can use this for a broad portfolio approach – perhaps with something like the iShares Edge MSCI USA Quality Factor Fund (QUAL). But you can also use this insight to find individual stocks of the highest quality.

We don’t know if the collapse we saw in March is over. I have thoughts (I tend to think we haven’t seen the bottom yet), but we can’t know for sure.

If the market remains strong from here, we want to start buying things on the cheap. But if we reach for the high-risk, high-return “junk” today, we could get burned.

That’s why “buying quality” is the perfect plan for this moment. The reason is simple… It works.

Here’s to our health, wealth, and a great retirement,

— Dr. David Eifrig

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Source: Daily Wealth