The Quality Rank

It has long been known that high quality companies outperform junk companies in the stock market. It makes sense doesn't it? Profitable companies generating sustainable cashflow at high rates of return really ought to be better investments than companies that are constantly loss making and eating shareholder's funds. Of course this is an open secret, and high quality companies generally become bid up to higher valuations over time. The trick is to find high quality companies at bargain prices. As Warren Buffett once said "When it comes to socks or stocks, I like buying high quality merchandise when it is marked down".

How does Stockopedia calculate the QualityRank?

Our QualityRank is based on a composite of carefully selected company factors based on the latest academic research into understanding 'Quality'. The factors used are inspired by the writings of Warren Buffett, Joseph Piotroski, Edward Altman and Messod Beneish, as well as recent papers from Robert Novy-Marx of the University of Chicago and National Bureau of Economic Research.

Each company in the market is ranked from 1 to 100 for each of these Quality Factors and a composite score is calculated as a weighted average of all these values. The QualityRank™ is then calculated between zero and 100 for this composite score, where 100 is best and zero is worst.

How has the QualityRank performed?

Our approach to ranking quality has proven powerful, as illustrated by the returns to annually rebalanced portfolios, grouped in 10 ascending quality buckets, in the UK since April 2013 below.

Stocks ranking between 90 and 100 by the Quality Rank have returned over 10% annualised over this time period before dividends. This is more than four times the benchmark return.

Guide to using the Quality Rank

It's worth remembering that the composition of the Quality Rank focuses on long term economics and stability, rather than current economics. This is then enhanced with an assessment of fundamental direction - whether improving or deteriorating. While generally the highest Quality Rank companies are among the strongest businesses in the market, there can occasionally be unusual selections in the high ranking mix.

A business that is having a poor run can score highly if its fundamentals show signs of improvement. While a business with high current profitability may score poorly if its fundamental trend is negative and its operating history is poor.

Salient, descriptive measures of quality are often poor predictors of future returns. For example, a high current ROCE may look impressive, but is also highly visible to the market. Research shows that short term bursts in profitability and growth often mean revert and may also be subject to earnings manipulation. Many of the studies listed illustrate that it's better to use less visible, and less manipulable measures of quality (like Gross Profits and Cashflows rather than Net Profits) if one wishes to target higher returns. So this is the approach we've taken in creating the Quality Rank. We aim for it to be predictive, rather than descriptive.

While the performance of portfolios constructed using Quality alone has been impressive, the true value of the Quality Rank comes when used in combination with other factors. While value investors have found that higher quality stocks in the bargain bucket outperform strongly, it's often a set of high flying stocks that generate the most impressive returns in any given year.