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- Quality: A guide for stock pickers
“I have the simplest tastes,” Oscar Wilde declared. “I am always satisfied with the best.”[1] Many successful investors, such as the legendary Philip Fisher, tend to take a similar approach to picking quality stocks. At a time of geopolitical, economic and technological uncertainties, the idea of compounding return by investing into a proven winner is appealing.[2]
Of course, that leaves the problem of how to recognize “the best.” In identifying high-quality stocks, the traditional distinction has been in terms of metrics encompassing offensive and defensive characteristics. Offensive traits include durable growth, innovation leadership and management quality. Defensive strengths relate to a solid balance-sheet, financial flexibility and shareholder-oriented capital allocation. Especially over the last 30 years, new techniques have emerged to refine traditional measures of quality and value creation more precisely. These are constantly refined further, as : our understanding of equities is still in the making.[3]
Over the last ten years, quality has outperformed the broader market
Source: Bloomberg Finance L.P., DWS Investment GmbH as of 11/21/23
On the other hand, a company which delivered great returns for ages may all of the sudden struggle. “Nothing fails like success,” as the business scholar Richard Pascale has argued.[4] Even the best-managed companies with a stellar track record, can become subject to what Clayton Christensen famously called "The Innovator's Dilemma.”[5] “In an age of disruption and fast-paced structural change, resiliency and adaptability are key quality criteria aside from hard financial metrics,” argues Sebastian Werner, Head of Growth Equities, Americas at DWS.
Adaptability includes undertaking investments even in uncertain times. Having the support of long-term-thinking and patient investors who understand the need to prepare for the next wave and see the potential of new opportunities early on helps. Resilience means risk-preparedness, operationally and financially as well as via diversification. Just as a good defense enables a good and effective offense, resilience is a precondition for adaptability, as it creates financial flexibility. In combination with continuous improvement, this can create a virtuous cycle, enabling market leaders to profitably grow further, independent of the macroeconomic circumstances.
Identifying such potential long-term value creators involves qualitative assessments of management, organizational flexibility and effective corporate culture. This takes a great deal of skill and effort. Conversely, the potential rewards from correctly identifying long-term winners have rarely seemed larger with so many unknowns lying ahead.
