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 characteristics have outperformed cap-weighted benchmarks, while also protecting capital during events as varied as the bursting of the technology bubble, the global financial crisis and the new coronavirus pandemic ( Display).

For more than a quarter of a century, the S&P 500 Quality has outperformed the broader market with less risk. 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 by holding stocks that tend to fall less than the market in a downturn, it’s easier for a portfolio to recoup losses quickly and outperform in a future rebound.

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 withstand a recession and thrive when conditions improve.

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, companies that scored high on quality measures such as earnings growth and profitability in the past might not continue to perform well in the coronavirus recession, as rampant demand destruction unfolds 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, with a better chance of survival through a recession.
• Strong Free Cash Flow—Good businesses generate excess cash, the lifeblood of economic activity, especially in a crisis when businesses are squeezed. 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. They’re also better positioned to withstand challenging conditions.

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.