Opinion – Grain in Grain: Discover the three criteria that determine the quality of an action

Attracted by the promise of high earnings, investors invest in stocks classified as junk (garbage), when they should look for quality. It seems almost obvious that quality should be a key criterion to pursue in stock investing. However, is quality really that important? And what determines the quality of an action?

If you’ve been following this column, you’ve read a few times about managing a stock portfolio through factors. One of the factors that performs best in the world and that is pursued by investor Warren Buffett is the quality factor.

According to MSCI, the stock index that follows the quality factor in the world (MSCI ACWI Quality Index) presented a performance of 296.54% in the last fifteen years. In the same period, the aggregate index, the MSCI ACWI, appreciated by only 144.73%.

Additionally, as shown by Andrea Frazini, in an academic article published in 2013 entitled, Buffett’s Alpha: “We show that Buffett’s performance can be largely explained by exposures to value, low-risk, and quality factors.” (We show that Buffett’s performance is strongly explained by exposure to value, low risk, and quality factors).

Therefore, the quality factor is one of the factors that explain the high performance of billionaire Warren Buffett. In other words, quality is important.

As the same author defines in an article published in 2019, the quality factor is determined by three key characteristics: profitability, growth and security.

To explain how to apply these three characteristics in rating the best quality stocks, I will comment on how MSCI defines its index.

In the article, Frazini describes several indices that can be used to meet the three criteria. MSCI selected among them very simply.

For profitability, MSCI considers the profitability of companies as measured by ROE (Return on Equity). For the growth criterion, it considers the growth of profits, but privileging the stability of this growth. In the security criterion, it classifies by low financial indebtedness, that is, the lower the indebtedness, the greater the security.

If you manage your own portfolio but are not able to rank stocks as simply as above, beware. you might be buying junk.

According to MSCI, examples of high quality global companies would be: Apple, Microsoft, Meta, Nvidia, Johnson & Johnson, Taiwan Semiconductor, Unitedhealth Group and Visa. Examples of quality Brazilian companies would be: Vale, B3, Ambev, Weg, Localiza, Itausa, Gerdau, BB Seguridade, Hapvida and Vibra.

It is important to understand that a company’s quality rating changes over time. Thus, a company classified with a high quality index today, may not be classified as such next year.

Note that an index calculated with simple criteria that portray the quality of a company is already capable of producing a good differential in return. As I mentioned yesterday, there are stock investment strategies that outperform investing in indices such as the Ibovespa.

If you want to invest directly in stocks, you must be able to build criteria for classifying companies in order to have a more efficient and quality portfolio.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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