Quality of Security

Factors to consider when picking stocks to invest in

What is Quality of Security?

Selecting the right quality of security is one of the most important factors to consider in investing. Security refers to a negotiable financial instrument that holds some monetary value and represents an ownership stake in a publicly-traded corporation, either through stocks, bonds, or options.

 

Quality of Security

 

The security ownership may be represented by a certificate, electronic record, or book-entry only form. The company issuing the securities is referred to as the issuer. The Securities and Exchange Commission (SEC) is responsible for regulating securities trading and protecting investors from fraud.

 

Summary

  • A security is a type of financial instrument that represents the holder’s ownership stake in a publicly-traded company.
  • Investors follow a defined set of criteria for identifying quality stocks based on the company’s quality characteristics.
  • The selection criteria consider factors such as the quality of balance sheet, valuation, and corporate governance.

 

What is Quality Investing?

Quality investing is an investment strategy that involves picking stocks of companies with superior quality characteristics. The concept was borrowed from real estate and bond investing, where investments are determined based on expert opinions and ratings from rating agencies. It was later adopted in the equities market to select stocks with the highest potential to earn profits based on the company’s quality characteristics.

The concept of quality investing was introduced in the 1930s by British-born American economist, investor, and professor Benjamin Graham, who identified the quality problem in equities. Graham grouped stocks into either low quality or high quality, depending on the issuer’s quality characteristics. He noted that the greatest losses resulted from buying low-quality stocks at a seemingly good value and not from buying quality stocks at unreasonably high prices.

The concept of value investing also became popular in 2001 after the burst of the dot-com bubble when large corporations like WorldCom and Enron collapsed, resulting in huge losses in investor funds. With the insolvency of these companies, investors gained awareness of security quality and started focusing their attention on important characteristics such as earnings quality, balance sheet, and corporate governance.

 

Characteristics of Quality Securities

Investors have a defined set of criteria that they use to determine the quality of securities. The selection criteria include the following factors:

 

1. Financial strength

Companies with strong financial strength can withstand adverse financial conditions or unexpected events in the markets. The financial strength of a company can be demonstrated by a strong balance sheet, a high volume of sales and profits, as well as the ability to generate sufficient cash flows to meet the operating costs of the company. Also, strong companies tend to report consistent positive results for several years in a row.

On the downside, companies burdened with debts will grow at a slow pace since a majority of the resources are diverted to pay the cost of liabilities. Investors can also use financial ratios such as debt-to-equity ratio and the interest coverage ratio to determine the financial strength of a company.

 

2. Economic moat

The term “economic moat” was coined by Warren Buffett to describe a company’s competitiveness in the market vis-à-vis its competitors. Quality companies possess economic moat, and it allows them to take a leading market position. Also, the company can protect its market share by creating barriers to entry to deter potential competitors from the market where it operates.

 

3. Corporate governance

Corporate governance relates to how a company is controlled and operated. Governance structures in a company determine how rights and responsibilities are distributed among participants in the corporation, and the procedures for making decisions relating to the company.

A quality company employs a professional management team that can see potentially lucrative opportunities and capitalize on them. Also, there should be low turnover rates among managers in the middle- and upper-management levels.

 

4. Attractive valuation

Valuation is an important factor in determining the quality of a company in its specific industry. Companies with attractive valuation are characterized by a low price-to-earnings ratio, price-to-book ratio, and a high discounted cash flow. A company that’s been able to maintain an attractive valuation over time can offer quality securities to investors looking for stable returns in the future.

 

5. Dividend-paying stocks

When looking for potential companies to invest in, investors are more interested in owning stocks in companies that pay dividends consistently. A history of consistently paying dividends to shareholders shows that the company’s reported enough revenues over the years to sustain its dividends payouts. Also, a history of dividend growth is an added advantage to investors, since they are assured regular and growing dividend payments over time.

 

Quality Investing vs. Value Investing

Quality investing is an investment strategy that differs from value investing.

Quality investing involves buying stocks from companies with outstanding qualities, while value investing involves buying stocks that are considered undervalued (trading below their intrinsic value).

Value investors pick stocks that they think are undervalued, since the stock price movements do not correspond to the company’s long-term fundamentals. The investors buy the undervalued stocks for the long-term, with a plan to sell them at a later date when their price appreciates.

 

Additional Resources

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Capital Markets
  • Interest Coverage Ratio
  • Growth Stocks vs Value Stocks
  • Quality of Real Estate

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