Quality stocks outperformed the broad market in good times as well as bad, in the long term as well as in shorter periods; they are expected to continue rewarding their investors in the future. Although hard work is needed to find the real quality, there are workarounds and cheat codes that investors can use to gain exposure to the best of the breed.
Don’t Fight the Fed, Unless it’s 2023
2023 turned out to be a great year for stocks. The rally that propelled the S&P 500 (SPX) up by over 23% (up to December 15) would go down in history books as one of the few times – if not the only time – when the markets broke the “Don’t fight the Fed” rule and won.
While the Federal Reserve continued to pound the table with its “the inflation is still high” mantra in each policy meeting, excluding the last one, signaling higher interest rates for a longer period, the markets brushed these warnings aside and went on partying. Now, after the Fed’s December meeting which featured a sharp turnaround including a projection of 0.75% interest-rate cuts in 2024, many investors are convinced that they’ve saddled the bull, ready to ride into the “happily ever after.”
However, 2023 was an outlier, with many factors conspiring to help the rally up, despite the interest rate hikes and the uncertain economic outlook, including the remainder of the pent-up demand from the pandemic times, as well as the companies’ and individuals’ swollen coffers, as a result of savings and federal aid of the Covid-19 era. Add to this an artificial intelligence (AI) craze that had the markets swooning with excitement, and you’ve got a recipe for an outstanding rally.
Past Performance Does Not Guarantee Future Results
But as this year is drawing to an end, investors must ask themselves whether they expect the same conditions to affect the stocks next year, too. Although extrapolation of the current trend into the future is a natural human trait, in the reality of the stock markets it is very counter-effective.
You don’t need to look further than the mutual fund performance in 2023. After a dismal 2022, going into this year most fund managers were positioned for the economic hard landing. These economy-negative biases received a strong confirmation at the time of the regional bank crisis in March, which prevented them from noticing the budding stock rally in time. They were heavily exposed to utilities, consumer staples, and other defensives which were expected to protect their holdings from falling too much in value during a recession, but instead strongly underperformed as the economy held up and the stock markets roared. Although most money managers rushed to update their positioning, they still underperformed overall. Even in the most high-flying stock sector, Technology, only 14% of mutual funds have succeeded in beating their benchmarks this year through October.
So, if fund managers, who are helped by teams of analysts and strategists, fail to predict market trends, how can individual investors succeed on this battlefield? With unbiased thinking and a little help, anything is possible.
Quality Gets the #1 Prize
Those who bought shares of Nvidia (NVDA), Tesla (TSLA), and Meta (META) before they surged over 100% within a few months, could rest on their laurels for the rest of the year. Many others were chasing their tails trying to match the performance of the “Magnificent Seven” IT giants, who were responsible for most of the S&P 500’s gains.
Even though this year’s rally was ignited and led by technology stocks, one non-technology-focused investment style still outperformed the broad market. This style is called “quality factor investing”: choosing the stocks of companies with solid management, robust business models, strong competitive advantages, healthy financial metrics, and sustainable earnings growth.
Bear in mind that quality stocks don’t equal defensive stocks or value stocks. While these factors may overlap, quality factor investors find their picks across all sectors, as long as these are solid and profitable businesses; they also put much less emphasis on price than value investors. As Warren Buffett once said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
“With a Little Help from My Friends”
Quality factor investments are best evaluated in the medium to long term: this investment style has outperformed the S&P 500 in the past two, three, five, and ten years. As said above, quality stocks also strongly outperformed the S&P 500 year-to-date. Not all individual one-year periods would be as successful for the style as 2023 has been, as in the short term, stocks are moved by a myriad of factors. However, periods associated with higher-than-normal uncertainty, as this year was, usually set the perfect stage for quality stocks.
So, as we are going into the next year hopeful, but probably more perplexed than ever, we may hold to one surefire bet that hasn’t disappointed investors: long-term, quality stocks will deliver. Or, as Warren Buffett put it, “In the short run, the stock market is a voting machine; but, in the long run, it is a weighing machine.”
But how can investors find these shiny diamonds of quality among the vast rubble of the stock markets? Well, it isn’t easy. To screen for quality, investors must look into the companies’ balance sheets and income statements, analyzing their finances and earnings growth; they should also check their market shares and business models, comparing them to their peers in the industry, and so on. Thankfully, that “little help” mentioned above is at the investors’ fingertips.
Practical Exercises in Quality Measurement
TipRanks provides investors with access to research done by Wall Street’s leading analysts, which can be easily utilized to their benefit. In addition, TipRanks has several handy tools that employ the vast amounts of data and research stored in its database, helping discerning investors pick the best stocks according to their outlook, risk tolerance, and financial goals.
For example, investors can use the Analyst Top Stocks tool, screening for analysts’ high-conviction “screaming buys,” or check the Top Smart Score Stocks list for stocks that have the highest potential to outperform the market. Additionally, investors can utilize the Stock Screener, filtering for Smart Score, price targets, analyst consensus, insider signal, etc.
Importantly, these tools, however invaluable, don’t fully replace the stock fundamentals analysis: it is still advised to check the relevant data on the chosen companies’ pages on TipRanks. However, there are two ways to avoid the hard work altogether. The first one is to subscribe to the TipRanks Smart Investor newsletter, which provides a managed long-term portfolio of high-quality stocks as well as a weekly quality stock recommendation.
Investors that are new to the quality-stock scene, or don’t wish to pick individual stocks, can still gain exposure to the best companies’ shares by buying into a quality-factor ETF which follows an index built specifically around solid fundamentals and robust earnings.
While there are several quality-factor ETFs on the market, I suggest picking the largest and best-performing one, the iShares MSCI USA Quality Factor ETF (QUAL). This exchange-traded fund tracks an index of U.S. large- and mid-cap stocks, selected and weighted by high return on equity (ROE), stable earnings growth, and low debt/equity, relative to peers in each sector.
QUAL has outperformed the broad market, as represented by the SPDR S&P 500 ETF Trust (SPY) in the long, as well as short term:
Source: Google Finance
