11 top-quality stocks benefitting from broker upgrades

Are stars of the future among these stocks with high returns, share price momentum and broker backing? 

The FTSE All-Share index has been on a tear of late, up by more than 10% in the year to date. What's more, on a forecast price/earnings (PE) ratio of less than 13 and a forecast yield of around 4%, it looks like there is plenty of room for growth. 

In such conditions, the biggest success stories are sometimes not obviously cheap stocks, but high-quality operators with improving outlooks.

Top analysts and investors such as Warren Buffett and Michael Mauboussin say capital allocation - the deployment of company time, money, ideas, and people - is the key to building moat-like quality and profitability characteristics. It is perhaps the most fundamental driver of future share price performance. If you find a company that consistently allocates its capital profitably, chances are you are onto a long-term winner.

Unfortunately, CEOs are not generally promoted based on their ability to allocate capital, even though this is what they then go on to spend time doing. Buffett sums it up nicely in his 1987 letter to shareholders:

"Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it's as if the final step for a highly-talented musician was not to perform at Carnegie Hall but instead, to be named Chairman of the Federal Reserve."

So, if you're only looking at sales and earnings growth, there is a vital question not being considered: how is this growth being funded?

Screening for upwardly mobile, high quality companies

That's where metrics like return on equity (ROE) can help. ROE measures how efficiently a company uses Shareholders' Equity to generate profits. It is calculated by dividing net income by book value of equity.

It's no coincidence that Buffett is a fan of the measure - companies with high ROEs tend to exhibit the high-quality, moat-like business traits that he is so fond of gaining exposure to.

But it's not as simple as just searching for the companies with the highest ROEs - take Plus500 (LSE:PLUS), for example. Online trading platforms continue to have high returns on equity, but regulatory uncertainty has hammered their share prices. 

What we want to find are high ROE stocks whose fantastic business models are being rewarded, not punished, by the market.

A nice and simple way to identify these stocks is to create a screen that selects only stocks with both positive one-year relative strength and upgraded current-year broker forecasts. The former ensures these shares have been outperforming the market and the latter suggests outperformance could continue. 

When we sort this screen from highest to lowest return on equity descending to, we get the following top 11 companies with high ROE, positive relative strength, and recent broker upgrades:

Source: Stockopedia

Sorting for high momentum, high ROE stocks predictably leads to some of the most high-profile names in the stock market. 

They are there for a reason - companies like GlaxoSmithKline (LSE:GSK), Compass Group (LSE:CPG), and Diageo (LSE:DGE) have arguably managed to build those fabled economic moats that Buffett seeks, transforming themselves into multi-billion pound market cap companies in the process. Their superior assets and business models make them formidable competitors and successful long-term investments. 

But other, smaller names also make the screen. Might household goods brand-owner Up UP Global Sourcing Holdings (LSE:UPGS) be a future stock market giant? Or can Softcat (LSE:SCT) sky-high ROE add a zero to its market cap in the years ahead? With more than 5% of the company, JP Morgan appears to be hoping so. 

These stocks can be expensive, no doubt, but some of the PE ratios on show aren't too demanding. Besides, with their high returns, share price momentum, and recent broker upgrades, these are exactly the type of stocks that deserve a premium valuation.

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