The fundamentals behind quality investing according to experts

There are plenty of investment strategies. From income/dividend investing, investing for value, growth, passive and quality investing. 

Some investors look purely for stocks that are undervalued, others for steady income.

However the team at Betashares has given a clear roadmap of the principles behind quality investing. 

What is quality investing?

Quality investing is an investment strategy that focuses on buying shares of financially strong, well-managed companies with durable competitive advantages. 

According to Betashares, there are three key fundamentals to consider when targeting quality companies.

The first is high return on equity (ROE). 

Essentially, the ROE indicates how efficiently a company uses its equity financing to generate income. 

Having a high return on equity means a company is capable of effectively using shareholder equity to generate profits, has the potential to fund expansion without incurring excessive debt and possesses an efficient business model.

The second metric to assess is a company’s level of leverage. 

Leverage is when a company borrows funds (takes on debt) to invest. The goal is for the debt to be invested successfully, generating returns that exceed the cost of servicing the debt. 

You can measure this by looking at the debt-to-equity ratio (D/E). 

A high D/E ratio is a warning that the company is at risk of financial problems. However, a low D/E ratio is also not ideal. You want to see that a company is using debt responsibly, rather than avoiding it altogether. 

The final metric to consider in quality investing is earnings stability. 

While the previous two metrics measure profitability and financial strength, earnings stability shows whether a company can provide this over a long period of time. 

According to Betashares, earnings stability measures the consistency with which earnings have been generated over time. 

It can be measured by looking at how much a company’s return on equity (ROE) has deviated from its average level over the past five years. 

The more that yearly ROE figures deviate from the average, the less stable the company’s earnings are considered to be.

In simple terms, quality investing targets companies with a high return on equity, low levels of debt (and leverage) and stable earnings. 

When does it work best?

Research from Polen Capital indicates that quality companies tend to outperform, particularly during late-cycle and recessionary periods. 

In contrast, quality investments typically underperform when low interest rates and accommodative economic policy are dominant macroeconomic features. 

According to Betashares, quality companies are typically more resilient in a downturn. 

Belief in a quality investing style is embedded in the logic that companies with a high return on equity, low levels of debt (and leverage) and stable earnings are, by their very nature, traditionally more resilient in a downturn and provide strong returns over most of the cycle. Their strong balance sheets and consistent cash generation can provide a buffer when market conditions deteriorate.

Quality investing-focused ETFs

If this strategy aligns with your investment goals, you can apply it to individual companies and target those that are outperforming their peers. 

Another option for investors who may want to take the work out of finding individual companies to invest in are ETFs that group these companies, such as the following:

• Betashares Australian Quality ETF (ASX: AQLT) – It reweights the largest Australian companies by quality metrics – high return on equity, earnings stability, and low levels of leverage, rather than market capitalisation.
• Betashares Global Quality Leaders ETF (ASX: QLTY) – Comprises 150 of the highest quality global companies.
• Betashares Global Quality Leaders ETF – Currency Hedged (ASX: HQLT) – Currency hedged version that may attract investors seeking to reduce exchange rate volatility.

The post The fundamentals behind quality investing according to experts appeared first on The Motley Fool Australia.

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Motley Fool contributor Aaron Bell 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 no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.