The Case for Investing in High-Quality Businesses

As famed investor 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.” We believe that’s a sound approach. High-quality companies, in our view, have an advantage in the marketplace. Generally, a combination of strong management, effective use of resources and a sustainable competitive advantage positions these businesses to outperform average or weak companies over the long run.

In fact, the average annual return for the top quintile of quality names in the S&P 500 as identified by the Bloomberg quality index over the past 20 years is 12.3 percent compared to 9.8 percent for the S&P 500.

Placing a premium on quality

It makes sense that companies with strong business models and low debt would trade at higher valuations, and that is what typically happens in the stock market. According to data compiled by the UBS Group going back to 2000, companies in the top quintile on the quality scale receive on average a 20–25 percent valuation premium compared to companies in the bottom quintile. That premium disappeared in 2022 and turned into a discount due to the dramatic increase in interest rates as the Federal Reserve tried to rein in record inflation.

Defining “quality”

While many agree on the value of holding quality companies in a portfolio, views on what constitutes a great business vary. That’s because some characteristics of quality are hard to quantify, including the company’s competitive advantage and strength of leadership. There are, however, some measures that focus on things (such as efficient use of assets or financial structure) that can be useful in deciding how a business stacks up on the quality scale relative to others.

Making more with less

Performance metrics, such as return on equity and return on invested capital, can be good measures to use when judging the quality of a business. Return on equity looks at profitability and how efficient a company is in generating profits. In mathematical terms, it is simply net profit of the business divided by the total value of shares outstanding. The higher the net profit number is relative to outstanding equity, the more efficient a company is at producing profits. Similarly, return on invested capital measures the return companies receive for each dollar of investment made into the business. Again, high-quality companies are generally those that can generate more profits with less financial resources.

Measuring financial strength

While profitability and efficiency are important in evaluating companies, so too is the financial stability of a business. Using debt to finance growth or for acquisitions may be a good idea when interest rates are low and the economy is booming, but significant debt can be a threat to a company that is facing a slowdown in sales or must refinance debt in a rising rate environment. With that in mind, debt to capital is an easy calculation that gives investors a clear look at how much debt a company owes relative to the value of its shares outstanding.

Other indicators of quality

Other factors that are used to judge the quality of a company may include items that can’t be measured through a calculation or ratio but are still relatively easy to recognize. For example, companies that are leaders in industries that are costly or difficult for new businesses to enter (e.g., commercial airline manufacturing) are often considered to be higher quality than startups with low barriers to entry and little product differentiation, such as T-shirt suppliers.

Setbacks have been few and brief

While seeking out quality businesses when investing has traditionally been a sound strategy, it isn’t foolproof. Quality as a factor lagged through much of 2022, and during the past 20 years, there have been three 12-month periods in which the top quintile of companies using the above-mentioned metrics have lagged the broader S&P 500. In each of those periods — 2006, 2012 and 2016 — interest rates were rising or the Federal Reserve was on the cusp of raising rates. However, as you can see in the table below, periods of underperformance have been followed by a strong rebound compared to the S&P 500.

Why another comeback for quality may have begun

The strong relative performance of high-quality companies over the last 20 years has not been in a straight line; however, the long-term trend is clear. While past performance is no guarantee of future results, recent returns raise the question of whether quality stocks are in the early stages of another cycle of outperformance. During the past five months, from Aug. 31, 2022, to Jan. 31, 2023, companies in the high-quality category have outperformed the S&P 500 by 3.7 percentage points. One of the key tenets of our equity investment process at Northwestern Mutual Wealth Management Company is the importance of overweighting high-quality companies in our portfolios. We do this because over the long term, high-quality companies have outperformed the S&P 500. With rate increases expected to slow or stop in the coming months and given our belief the economy could enter a shallow, mild recession, we believe valuations for high-quality companies could return to their historic norms and could result in high-quality businesses becoming performance leaders once again.

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