The hunt for quality allows investors to tap equity return potential with smoother return patterns. Quality stocks with the right attributes tend to offer superior risk-adjusted returns, posting solid gains in rising markets and cushioning investors in a downturn. Over time, stocks with these all-weather characteristics have helped protect capital during events as varied as the bursting of the technology bubble, the global financial crisis and the coronavirus pandemic (Display).

For nearly 35 years, the MSCI Quality Index has delivered an annualized return of 11.1%, outperforming the broader MSCI World benchmark by 3.8% a year (Display). But to position properly in crisis periods, quality control is crucial. Investors who concentrate on quality in their everyday stock-picking processes are better equipped to identify durable companies that have what it takes to get through uncertain times and to thrive in a recovery.

WHAT DISTINGUISHES TRUE QUALITY?

Capturing the superior risk-adjusted returns that quality stocks offer requires a forward-looking approach and identifying the right measures to pursue. We believe that sturdy balance sheets, high and stable profits and strong free cash flows are good ways to identify companies with the ability to perform well through changing market conditions.

Passive approaches use various measures to define quality, but they’re backward looking. This presents a severe flaw in systemic crises, particularly the COVID-19 pandemic, in which the future will look nothing like the past. For example, some companies that scored high on quality measures such as earnings growth and profitability in the past faced pressure in the coronavirus recession, as rampant demand destruction unfolded in unpredictable ways.

THREE INTERCONNECTED FEATURES

To find quality today, investors need a discerning view of a company’s underlying dynamics. By studying industry conditions, demand drivers and company business models, investors can assess quality using these three lenses:

• High and Stable Profitability—This is usually a sign that a company has a differentiated and durable business that can do well through changing macroeconomic cycles.
• Strong Free Cash Flow—Good businesses generate excess cash, the lifeblood of economic activity. This gives companies more financial flexibility to enhance shareholder returns.
• Healthy Balance Sheets—Companies with ample cash and low debt levels have a healthier foundation to invest for the future and execute strategy without being subject to the moods of capital markets.

The three characteristics above are interconnected. Companies that generate consistent free cash flows are in a better position to cover debt-servicing costs—even when there’s less cash to keep the business afloat. And low earnings volatility is a good indicator of a company’s ability to perform through complex and changing business conditions.