By Eric Dutram, DWS
Anyone starting a new diet knows that there is one factor to watch out for more than anything: quality. Quantity is definitely important as well, but you are more likely to make progress if you focus on unprocessed, natural foods.
While it can be extremely difficult to cut back on the snacks, leaving the junk food behind in a new diet regimen is often the only way to make a lasting improvement. So although a number of other factors can contribute, quality needs to be at the center of the process, no matter how tough it might be.
The same might be said about investing. But unlike nutrition, it can be a whole lot easier to build a quality investment portfolio than a quality-centric diet. To do this, investors have specific factors to help guide them. Think of them like the nutritional components of a stock. These factors help to explain various stocks’ risk and return profiles. And different equities can be blended to build a proper ‘diet’ or portfolio.
Quality in Investing
While quality in the food world might consist of labels such as organic, low-sodium, or no trans-fats, in the investing world the equivalent factors are things like profitability, earnings stability, financial leverage, and corporate governance.
Related: Multi-Factor ETFs: Great Long-Term Investments
There are a number of ways to achieve quality in these key areas. Some of my personal favorites are focusing on companies with high readings for their return on equity (ROE), a figure which helps to demonstrate how shrewd a company is with investor capital; solid earnings growth, which can be an indicator of a nice financial trend; low market leverage, which gives managers options for the future; and a strong shareholder rights policy, ensuring that those with ownership get a say in how things are run.
Much like a diet, there are a number of ways to get the job done beyond the most popular and obvious components. A more complete—but by no means exhaustive—list of metrics to watch for in terms of investing quality is below:
It isn’t just about quality
Anyone who has shopped in the organic section of a supermarket will tell you that quality often doesn’t come cheap. Usually you have to pay up for quality, making value an important factor to consider as well. After all, anyone can build a great diet for an inordinate sum; it is much more of a skill to build one with a more limited budget. In the financial world, a focus on value can help to avoid expensive equities and allocate more to quality names that present attractive choices for long-term gains.
This can be done by analyzing key metrics such as cash flow yield, earnings yield or price-to-sales ratios. By combining these factors and ranking securities that have already passed a strict quality test, you can be more confident that you aren’t just buying any quality names, but tilting towards stocks that are potentially more likely to be worth the money.
Bottom Line
It is possible to build a great diet — or a portfolio — by only considering quality metrics. However, such a focus is likely to result in overpaying for top-notch items. So while one might consider focusing extra on quality, contemplation of the value component is advisable as well.
Combining these ‘nutritional’ building blocks in the equity market can be key to creating a lean and healthy investment plan. It’s simple, really: use discipline when identifying ‘quality’ as well as ‘value’ to create a better portfolio.
If only dieting were so easy!
For more on investing with factors, make sure to check out our guide and videos on this topic: Factor Investing Explained.