How to Find Quality Stocks
Markets have turned volatile again, with the Dow down for the past five weeks straight, losing nearly 5% of its value in the process.
When markets get turbulent like this, I always stress the importance of investing with a margin of safety.
In many Wealth Watch articles, I have advocated for a strict focus on high-quality, dividend-paying blue chip stocks as the best defense in a volatile market environment.
But what is quality anyway? And how do I go about identifying top-quality stocks?
Quality, like beauty, is very much in the eye of the beholder. So you must make a few subjective judgements, but that’s true of most consistently successful investment strategies.
With that in mind, in this article I’ll share with you my seven simple rules of thumb for selecting high-quality companies to own for the long run. The simple steps listed below have consistently helped me find stocks that deliver market-beating results.
In fact, I track a model portfolio of about two dozen stocks that make the grade according to my criteria. As a group they’ve delivered a 15% return year to date, which beats the Dow’s 10% gain so far in 2019 by a wide margin.
And above all else, this is a resilient portfolio that lets you sleep well at night without worrying so much about volatile markets.
So let’s dive right in…
1. Choose Dominant Businesses: Sure, there are plenty of hot IPOs like Uber that could make you rich, but I like the tortoise approach: Slow and steady wins the race.
That’s why I focus my search on stocks with large market capitalizations, at least $10 billion. That way, at least I know I’m dealing with a stock that’s been around the block a few times and prospered through thick and thin.
2. Search for Consistent Dividends: Research demonstrates that up to HALF the total return from stocks over time comes from cash dividends and the reinvestment of those dividends. That’s why I search for companies with dividend yields at least equal to, and preferably higher than, the S&P 500 yield (which is about 2% right now).
Plus, insist that the dividend has been raised in at least eight of the past 10 years.
3. Cash Flow Doesn’t Lie: A company’s cash flow should be consistently positive and exceed its net income. Companies can play all kinds of fuzzy-math games with what is considered “income,” but it’s much harder to fudge the cash flow numbers.
Strong cash flow is what allows a company to increase dividends, buy back its shares and invest to grow the business.
4. Follow the Peter Principle: Invest in businesses that are easy to understand or, as legendary fund manager Peter Lynch puts it:
“If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth-grader could understand… The worst thing you can do is invest in companies you know nothing about.”
That’s great advice, and following it will keep you out of trouble.
5. High Quality: Insist on quality businesses that have not only survived but thrived in good times and bad. These are quality companies that deliver consistent earnings and dividend growth. The best way I’ve found to identify such stocks is to only invest in companies with an S&P Quality Ranking of B or better.
6. Improving Prospects: The key to earning market-beating returns is buying the right companies (see above) at the right time. When you consider buying a new stock, be sure the consensus earnings estimates are rising, not falling, and that profits are expected to grow over the next few years.
7. History Rhymes: History may not always repeat exactly, and the winning stocks of tomorrow may be different than today’s winners. But get a historical perspective on any company you’re willing to invest in. Take a close look at the company’s historical results, say, over the past decade. This will give you a much better idea about its future potential.
Pull up a stock report from your online broker and browse the past 10 years of results. Do you see fairly consistent growth in sales, earnings, dividends and stock price? A few off years here and there are OK, but do you see a pattern of consistent growth? If yes, then it’s a keeper and worthy of further research. And if the stock doesn’t have 10 years’ worth of history, pass, because it hasn’t yet stood the test of time.
By following these seven simple steps, the intent is to build a balanced portfolio of quality stocks of different sectors and investing styles. There’s a little bit of something here for everyone: quality, growth, income, value.
These guidelines are NOT meant as hard-and-fast rules, either. But use them to filter the thousands of stocks that are available down to a manageable list for further research.
In another Wealth Watch article later this week, I’ll show you how to go about finding the data you’ll need to evaluate stocks by my seven simple rules of thumb using easily accessible websites.
Here’s to growing your wealth,
Chief Income Expert, Mike Burnick’s Wealth Watch