In the first of this new mini series, I’m going to present a checklist showing the process I work through when I’m looking for quality shares that I might be interested in buying.
In subsequent articles, I’ll also follow the same process for income and growth stocks, so stay tuned.
What’s a quality stock?
A true quality business is one that generates above-average returns and is able to continue growing sustainably without sacrificing profitability.
Such businesses are often – perhaps inevitably – expensive. But their ability to compound returns at attractive rates means that they may still be able to outperform the market.
One good example of this is FTSE 100 publishing and data group Relx (LON:REL). This business has often looked expensive to me, but has comprehensively outperformed the FTSE 100 over the last 10 years:
Not all quality stocks will deliver such marked outperformance. But this kind of chart is the ideal I’m hoping for when I look for quality stocks.
Here’s a summary of the checklist process I use to try and find quality compounders.
What do the numbers say?
As a systematic investor, my stock picking process always starts with a screen or checklist. I want to find companies that have the financial characteristics I’m looking for. If they do, I’ll then take a more in-depth look at the broader qualities of the business and its valuation.
There are three non-negotiable financial attributes I look for in a true quality stock:
Profitability
Return on capital employed, or ROCE, is generally seen as the single most important profitability metric for quality investors (for non-financial stocks).
If you’re not familiar with ROCE, Ed has written a detailed explanation here explaining what return on capital means – and how a high ROCE can contribute to multibagger gains like those delivered by Relx.
As a rule of thumb, I’d expect a true quality stock to have a five-year average ROCE of at least 15%. I can check this quickly and easily using profitability metrics on the StockReport:
The other main profitability metric I use is operating margin. This expresses the difference between a company’s revenue and its operating costs, including cost of goods sold.
Operating…
