6 criteria for picking quality stocks (and 3 ASX 200 shares that meet all of them right now)

Woman in pink shirt ticks checklist with red checkmarksWoman in pink shirt ticks checklist with red checkmarks

The share market has seen plenty of volatility since the start of 2022. Senior analyst Bruce Du from IML has outlined why investors should focus on quality (S&P/ASX 200 Index (ASX: XJO) shares, particularly at times like this.

He points out that when bad weather hits a city like Sydney, we see cheap, low-quality umbrellas perform poorly and are sometimes abandoned by their owners. A similar thing happens when fear hits the share market. Investors leave low-quality companies and look for a place of shelter.

Du wrote:

But while it’s pretty easy to spot a low-quality umbrella, low-quality companies can often seem like they have exciting prospects while in reality they have little substance to them. Definitions of what makes a ‘quality’ company vary and many companies are experts at marketing their positive attributes, while hiding their shortcomings.

What makes a quality ASX 200 share?

Du believes that during times of heightened volatility and uncertainty, quality companies are “better placed to ride out the rough weather.”

There are a few different things that IML believes a quality company has, including a competitive advantage, recurring earnings, capable management and reasonable growth prospects.

He noted that high-quality management is “crucial” at a time like this because the business needs to be able to manage a changing environment and make good decisions in difficult times.

There are a couple of areas that could be particularly important for resilience during times like this – having a strong balance sheet and having pricing power/scale.

The pricing power allows companies to raise prices to offset increasing costs. Scale enables companies to have buying power to keep costs lower than competitors.

The balance sheet gives companies security and can also allow them to make the right long-term decisions even during short-term operational stress.

Which names tick all the boxes?

There were three ASX 200 shares that Du named which meet all of the criteria: Sonic Healthcare Limited (ASX: SHL), Medibank Private Limited (ASX: MPL) and Lottery Corporation Ltd (ASX: TLC).

Sonic Healthcare was described as a medical diagnostics business. It’s reportedly the number one pathology business in Australia, Germany, Switzerland and the UK, while being number three in the USA.

Du said that Sonic has competitive advantages with its technology, brand and medical specialists. It also has a strong balance sheet, with little debt, that can enable it to grow through acquisitions. It has the scale to drive harder bargains with suppliers. Finally, the analyst pointed out that the ASX 200 share has good growth prospects because diagnostic testing is a growing industry and the global population is ageing.

On Medibank, it was noted by Du that the business suffered from the cyber attack, but IML increased its holding because it scored highly on its quality metrics. The private health insurer “lost less than 1% of its policyholders due to the incident” and growing customers again.

The analyst said that the ASX 200 share has a strong brand, with “very strong levels of customer satisfaction.” Another point was that it has a leading position in a growth industry because of Australia’s growing and ageing population, which will need more medical care. There’s also an “increased importance placed on health through COVID”. The business’ leading position enables it to keep claims costs down and realise efficiency benefits, and it can also lift prices annually. Plus, it has no debt with a strong balance sheet, giving it more resilience.

On The Lottery Corporation, Du said it’s Australia’s leading lottery business which has “very high-quality, long-term and monopoly licenses”. This “effectively shut out competition”. The analyst suggests that the ASX 200 share has a loyal, engaged customer base that continues to use the products through all parts of the economic cycle, giving it “resilient, recurring revenue”.

Du also suggested that The Lottery Corporation has good growth prospects. More tickets being bought digitally these days means that less money is being lost to commission, so margins are improving. The analyst pointed out that a few years ago around 15% of customers bought tickets digitally, but this has increased to 38%. It can continue to grow margins through digital sales, while it also gives an “effective direct marketing channel to its customer base.”

The post 6 criteria for picking quality stocks (and 3 ASX 200 shares that meet all of them right now) appeared first on The Motley Fool Australia.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has recommended Sonic Healthcare. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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