The Quest for Quality & How to Find It

When contemplating which stocks to buy, there are several different ways to break up the market. Companies can be segregated by country or sector, but we can also look at their particular attributes. We look at why investing in ‘quality’ is worth considering in the current environment.

Tim Rocks, Chief Investment Officer at E&P Research, says to seek out ‘quality companies’ you firstly need to identify the attributes that represent ‘quality’. At E&P Research, we find quality by favouring companies who:

• are the dominant player in the industry in which they operate
• earn high margins, and have a strong ability to control prices, and
• tend to have lower levels of debt.

Cost control and pricing power

Rocks says as we start to see more inflationary impacts on businesses, these three attributes are particularly important for several reasons.

“Firstly, businesses with these drivers will be better able to cope with rising costs. Even if a spike in input costs or wages affects profits in the short term, they are in an effective position to pass those costs on, given their pricing power. The advantage is paramount – because such companies will cope better with rising costs and weakening demand,” he explains.

Rocks adds that if a company is dominant in their particular industry sector, they are in an even stronger position to be able to influence prices and manage their own costs.

“Pricing power and industry dominance are what so many businesses look for― but so few can achieve. So, when you have that combination, it opens up fresh investment opportunities because of the company’s ability to remain flexible and adapt to a range of economic conditions,” he says.

Look outside cyclical sectors

Secondly, Rocks explains that quality companies tend to operate in less cyclical sectors, so will be more immune from some of the current economic risks.

“Less debt means less effect from rising interest rates, which is particularly relevant in the new rising rate environment. Cyclical companies don’t often have that luxury,” he says.

Finding quality in a selloff

“More broadly, during market selloffs, what are perceived as quality companies tend to be sold off, along with some of the more challenged companies. However, they also regain their previous market price faster than other companies. So, corrections can provide a good opportunity to upgrade portfolios by picking up quality companies at lower prices.”

When conditions for equity markets are similar to what we are currently seeing, Rocks says there is quality to be found ― you just need to know where to look. Investors should stay close to their adviser.