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Questor: this graph tells you why we have such a strong preference for ‘quality’ stocks

Graph of stock performance

Questor share tip: companies that meet certain ‘quality’ criteria have hugely outperformed – and smaller ones have done best of all

We are not tipping a stock today: we are tipping an investment style.

The graph shows why.

It covers four different types of stock, and the huge difference in performance between the best and worst is immediately obvious.

The best category, with annual outperformance over effectively risk-free assets of 8.5 percentage points, is small, “high-quality” stocks. The worst, which has returned less than risk-free assets, is small, “low-quality” stocks.

Good returns, with annual outperformance of 6.2 percentage points, have come from large, high-quality stocks, while the fourth category, large, low-quality stocks, has produced mediocre gains.

The categories are subsets of the global stock market and the risk-free assets used for comparison are American “Treasury bills”, short-term bonds issued by the US government.

The lessons the graph tells us are, first, that high-quality stocks make better returns and, second, that smaller high-quality stocks do better than large ones.

Questor has referred approvingly to high-quality stocks on many occasions but what do we mean by that term?

The definition used by the firm that produced the graph, AQR, a US asset manager, was that a quality stock offered high profitability, growth, “safety” and “payout”.

Profitability meant good returns on capital, profit margins and cash generation; safety referred to low correlation to the overall stock market plus low volatility, debts, volatility in return on assets and bankruptcy risk; and payout referred to dividends and the like. A “small” stock was in the bottom 20pc by size.

The graph came to our attention courtesy of Montanaro Asset Management, which describes its own investment style as “quality growth”.

The company told Questor that its stock-picking criteria were similar to those identified by AQR as hallmarks of quality stocks, adding that it avoided firms with “incomprehensible or heavily adjusted accounts or unproven or unreliable management” and those that faced “structurally challenged business models with stiff competition”.

“Banks, retailers and mining companies are examples that would not be considered high quality – and they have been a tricky area for investors in recent times,” it added.

The firm conceded that high-quality stocks tended to be more expensive. “But we would rather pay more for a higher-quality, more predictable company that can be valued with greater certainty,” it said. “These companies also deliver higher earnings growth with less volatility. Quality investing helps you to sleep more easily at night and our strong record indicates that it works.”

Do we intend every Questor tip in future to be a small quality stock? Certainly not. We try to offer something for investors of every kind, and some readers prefer the greater stability that larger companies such as those in the FTSE 100 can offer.

Equally, many like the opportunities a “value” approach to investing can throw up; often the companies concerned fail the “quality” test but may make up for it in cheapness or in, say, backing from assets.

Questor will remain a broad church. But there is likely to be some bias towards quality stocks; some will be smaller companies, because this is where the greatest growth prospects, and the greatest chance of finding an overlooked gem, are to be found.

Let us know what you think: our contact details are in the box below; alternatively, message us via the Questor WhatsApp group.

Update: RPS

We tipped this environmental consultancy in February and four months later it issued a profits warning that sent the shares sliding. Interim results on Aug 1 beat (low) expectations.

Alex Magni of Montanaro, on whose holding of the stock we based our tip, said there had been “considerable deterioration in the perceived quality of earnings” at RPS, although he expected further recovery in the share price. We will keep a close watch but for now will hold.

Questor says: hold

Ticker: RPS

Share price at close: 128p

Read the latest Questor column on telegraph.co.uk every Sunday, Tuesday, Wednesday, Thursday and Friday from 6am.

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