6 Common Characteristics of Quality Growth Stocks

This article was written by James Yeo and first appeared on Investor-One.

By and large, investors find it hard to adopt quality investing because there is no definite answer to the essence of quality investing.

However, quality investing can be explained as an investment strategy that seeks to identify companies with both good qualitative criteria (e.g. management credibility) and hard criteria (e.g. good financial position).

That said, here are some common characteristics in quality stocks investors can look for:

1. Industry Trends

In the current fast moving global economy, it’s important to consider the enterprise life cycle or industry. A stock compounder needs to benefit from the tailwinds of long-term growth trends.

Current global growth drivers include 5G, IOT, health-care demand, urbanisation and e-commerce/online structural shifts.

One instance is how Shopee is benefiting from the boom in E-commerce especially in South East Asia as well as mobile gaming.

These factors have helped the business to increase its revenue by leaps and bounds over the past years.

2. Economic Moat

Warren Buffett used the term “economic moat” to describe competitive advantages a company has over its competitors. Competitive advantages can protect a company by creating barriers to entry for potential competitors.

These stock compounders tend to generate high margins too as high operating-profit margins are an indicator of a robust competitive position.

For instance, Facebook has generated a robust 80+% gross margins and 30+ net margins in the past 5 years.

What matters, though, is the sustainability of margins. Companies need competitive ‘moats’ to keep rivals at bay. These include strong brands, network effects, switching costs, economies of scale, patents and distribution channels.

3. Capable Management Team

If good management is an economic moat, it is actually an ‘intangible asset’ that is tough to beat. They have the ability to see long term opportunities and capitalize on them.

Ideally, investors should look for companies with management teams that have the following:

• Good track record
• Healthy ownership levels
• Reasonable compensation package
• Low turnover rates throughout upper management (i.e. CEO, COO)

One good example is Sheng Siong where the top brass has sizable interests in the company and grown the firm’s topline by 241% in the past 10 years. Sheng Siong also came into the limelight on Jan 2021 after it decided to reward all its employees with up to 16 months’ bonus after a terrific COVID-induced performance in 2020.

4. Strong Balance Sheet

Nearly every financial crisis can be traced back to a foundation of weak balance sheets that collapsed under the pressure of excessive debt.

Aside from a crisis, companies with high debts are still burdened with resources being diverted to service the liabilities. There are also the risks that they cannot continue to reinvest in the biz and gets stuck in a rut.

Hence, quality companies with strong balance sheets are well-positioned to withstand adverse conditions or unexpected challenges ahead.

5. Earnings Stability

One of the most overlooked criteria is earnings stability. Simply put, earnings stability lowers the probability of forecasting errors and therefore reduces risk.

A company with erratic earnings makes forecasting less predictable results in more room for error. Investors also tend to stay away from companies with wild volatility of earnings.

6. Dividend Paying Stock

Companies with a long history of growing dividend payments are a hallmark characteristic of quality companies.

In the U.S., there are many dividend aristocrats - or commonly known as S&P 500 index constituents which have increased the dividends for at least twenty-five consecutive years.

These companies include household names such as Colgate-Palmolive, Coca-Cola, 3M and more. And this is hard to see why they are considered as quality companies too.

Conclusion

In a nutshell, quality investing gravitates towards high-quality stocks that have winning business models, sound fundamentals and good management teams.

With all the positive characteristics in place, these durable quality companies with a strong competitive position like Apple, Microsoft, Coca-Cola and more can keep growing to increase their intrinsic value.

Last but not least, they have historically provided higher returns and outperform low-quality stocks with the opposite characteristics, especially in down markets.

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