What does Warren Buffett look for when shopping for a company?
Knowing his value bias, he tends to go for quality, durability and a reasonable price — things that can go a long way to making an investment profitable in the long run.
Focusing on quality can also pay off when it comes to stocks for your own portfolio.
Quality can mean different things in a stock, but it usually comes down to a few key factors: balance sheet strength, high returns on assets or invested capital, and a business with a strong competitive advantage that helps keep rivals at bay.
The consumer staples sector — where Buffett recently made a big acquisition, buying H.J. Heinz — has many such companies. But quality names can also be found in cyclical sectors such as materials, industrials and technology, says Lauren Romeo, a portfolio manager with Royce Funds in New York.
"To borrow Warren Buffett's term, you want a company with an 'economic moat' that makes it difficult for competitors to chip away at returns," she says.
A buffer against rising rates
For good reason, quality stocks are viewed as safer and more stable investments than companies with shakier businesses. Companies with strong balance sheets and cash flows don't need as much outside financing to run their operatons. That can help them glide through a financial crisis, emerging stronger on the other side.
Higher interest rates — which are pressuring some stocks now — also pose less of a problem for these businesses, says Eric Schoenstein, a portfolio manager with Jensen Investment Management in Portland, Ore.
When rates rise, companies that need lots of debt financing — think REITs or utilities — typically get hit hard as their borrowing costs increase. A more self-sufficient business can keep its financing costs down and maintain profits without as much impact.
"There's an opportunity for quality companies that are solid and consistent performers to stand out in this climate," says Schoenstein.
The price of quality
There's a price for this margin of safety. Quality companies tend to command higher price-to-earnings multiples than weaker rivals, due in part to their strong finances and business.
The ideal mix is both quality and value, says Sean Gavin, a portfolio manager with Fidelity Investments who recently co-authored a paper on the topic.
There are times when quality outperforms, such as late in a bull market and during a market downturn. But value stocks fare better at times too. Ideally, investors should look for both features in a stock to increase their odds of outperforming.
"It's always a balance between quality and value," Gavin says.
Granted, quality doesn't always pay off. Coming off a bear-market low, the riskiest stocks tend to soar, in part because they plunged the most.
Yet quality stocks tend to outperform in the middle and latter stages of a bull market, says Gavin. And they appear to trounce low-quality in the long run. Over the past 25 years, the highest quality stocks in the Russell 1000 (.RUI) beat the lowest quality in 75% of annual periods ending in June 2013, according to the paper he co-authored.
|STOCK||P/E RATIO||DIVIDEND YIELD|
|Reliance Steel & Aluminum (RS)||11.5||1.8%|
|Towers Watson (TW)||16.1||0.5|
|Becton, Dickinson (BDX)||16.0||2.0|
How to invest
One ETF to consider in the space: the iShares MSCI USA Quality Factor ETF (QUAL).
Launched in June, the ETF holds around 125 large and mid-cap U.S. stocks, tracking an index of companies screened for high returns on equity, a stable earnings history and strong balance sheets. Top names in the ETF include Apple (AAPL), Chevron (CVX) and Home Depot (HD) — leaders in their industries. The ETF's expense ratio is just 0.15%, or $15 for every $10,000 invested, and it yields around 1.7%.
The downside: Technology stocks account for 38% of the ETF's assets — roughly double the weighting of the S&P 500 (.SPX). Returns on equity aren't always the best measure of quality. The ETF's yield is below the market average.
Another way to go is to build your own quality-stock portfolio.
Buying individual stocks is always riskier than using a fund, but there are ways to reduce risk. Invest gradually over several months, for one, and make sure you're diversified across sectors and market caps. Stock volatility declines over time, moreover, so having a long time frame is especially important when investing in individual stocks.
Based on interviews with fund managers and our own research, we found six stocks to consider. As always, you should do your own research or consult an adviser before investing.
Steel, soft drinks and tech
Reliance Steel & Aluminum (RS) provides steel and services to manufacturers and construction companies.
Growth has picked up with the economic recovery, says fund manager Romeo. And the Los Angeles-based company should get a tailwind from a rebound in commercial real estate construction, which typically kicks in after housing construction starts to recover.
Reliance also has the size and scale to ward off competitors, Romeo adds. Solidly profitable with a return on invested capital above 10%, the stock could rise 33% from recent prices around $72 a share, she figures.
The downside: A downturn in the economy would likely depress steel prices. The dividend yield is just 1.8%.
Food-and-beverage giant PepsiCo (PEP) generates 9% returns on assets and 30% returns on equity — two signs of quality and profitability, says fund manager Schoenstein, who owns shares in the Jensen Quality Growth Fund (JENSX).
PepsiCo's earnings per share have been flat since 2011 and revenues slid 1.5% in 2012. But analysts expect growth to pick up, driven by foreign sales, expansion of its nutrition business (fruit juices, oatmeal and the like) and cost-cutting.
The downside: Higher raw-material costs and slowing soft-drink consumption in developed markets could hurt the stock.
Research firm Gartner (IT), based in Stamford, Conn., helps businesses figure out new technology trends like cloud computing and data analytics. Gartner analysts write reports and consult with companies on these trends, which are upending entire industries. And the business is thriving, says fund manager Romeo, who owns the stock in the Royce Premier Fund (RPFFX).
Gartner generates high returns on invested capital — above 60%. Overall, the company offers a way to profit off tech trends without betting heavily on just one. "It's a chicken tech stock," says Romeo.
The downside: At around 24 times estimated earnings, the stock trades at a rich premium to the market. Gartner pays no dividend and would likely come under pressure given a slowdown in tech spending.
Consulting, syringes and cutting tools
Towers Watson (TW) is one of the largest employee-benefits consulting firms and it's a "sticky" business, says Romeo, with the vast majority of revenues come from large, repeat customers. The business is growing around 5% a year and returns on equity are a healthy 15%.
One promising new area: health-care exchanges. Companies like IBM (IBM) and Time Warner (TWX) are planning to shift retirees to the exchanges, Romeo notes, and firms like Towers Watson, based in New York, are managing the shift and the benefits.
The downside: Weaker employment trends and adoption of health-care exchanges may pressure sales. The dividend yield is just 0.5%.
Medical products supplier Becton, Dickinson (BDX), based in Franklin Lakes, N.J., is one of the biggest makers of glass vials, syringes and other medical products. Revenues are growing just 4% a year, but it's a profitable business with 11% returns on assets and 25% returns on equity.
One potential growth driver: a new line of syringes pre-filled with drugs — products that can save hospitals money and reduce infection rates, says Schoenstein, who recommends the stock. The new syringes are now a small share of Becton's business but could grow substantially. The company plans 20 to 30 products in the space in the next few years.
The downside: Health care cost pressures could hurt Becton's profits. Shares are trading at the upper end of their historical range, according to William Blair analyst Brian Weinstein, who nonetheless has an "outperform" rating on the stock.
Industrial companies need metal-cutting tools and Kennametal (KMT) is one of the world's largest suppliers. Sales are expected to dip about 2% this fiscal year, but analysts expect sales to grow 4.5% next year and 5.6% the year after.
The company is taking steps to improve profitability, such as closing factories and selling less profitable businesses, says Romeo, who recommends the stock. Returns on equity are also improving, indicating the company is boosting value for shareholders.
"They're poised to benefit from the global economic recovery," she says, figuring the stock is worth around $53 a share, up from $46 recently.
The downside: Shares could take a hit on signs of slower economic growth in the U.S. and abroad. The stock has above-average volatility and a dividend yield of just 1.6%.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.