How to beat the market: how, why and when quality investing works

Want to beat the market? Then buy shares in the world’s best companies.

While this seems an almost naively obvious approach to investing, there’s plenty of evidence it works. That includes an investing-by-numbers system we’ll explore that has outperformed the UK market by 388% over a decade. This is one of four strategies covered in my new book Four Ways to Beat the Market.

A strategy of buying the best is often called “quality” investing.

In this article, we’ll explore how quality investing works, why it works, when it works and the traps investors can fall into. We’ll also find out ways to identify quality stocks and discover the UK stocks my by-the-numbers system is highlighting right now.

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How quality investing works

Investing is about putting money to work in the most effective way possible.

Investors in equities do this by trying to pick the most compelling shares. The companies that issue those shares do it by allocating their cash to whatever they believe will produce the best return.

Quality investors focus on companies that are very good at doing this by investing in themselves. Such companies need to have both a strong edge over their competition and a growth opportunity.

These companies are rare beasts but are well worth seeking out.

The real draw is the ability of quality companies to “compound” shareholders’ wealth. Albert Einstein is said to have called compounding “the eighth wonder of the world”. An example helps explain why.

Let’s imagine a quality company that can consistently make a profit of 20% on the money it invests in growing its business.

It starts out with £1 million to invest. This is the company’s initial “equity”.

Based on a 20% return, after a year the £1 million invested will have generated a profit of £200,000 (20% of £1 million).  

The £200,000 profit is reinvested to grow equity to £1.2 million. That means in year two the company generates 20% on £1.2 million. That’s a £240,000 profit.

Reinvesting profits from year two means starting year three with £1.44 million of equity. 20% of that is a £288,000 profit, which can again be reinvested. So the process goes on.

What is so staggering about compounding is the astronomical size of gains when the process goes on for a long time.

Incredibly, the snowball effect of our company reinvesting profits would be to turn the original £1 million of equity into £1 billion in just under 38 years. A 1,000-fold return.

What’s more, based on the 20% return on investment, that £1 billion of equity would be able to generate profits of £200 million the following year - 200 times the original equity of the company.

Why quality investing works

These kinds of returns are hard to get our heads around.

The reason for that is because it’s human nature to think of progress in straight lines. But the shape of growth through compounding is an upward sloping curve that gets ever steeper.

Over time, compounding’s curves make a mockery of our straight-line thinking. Investors find such lofty hopes hard to price in – often with good reason, as we’ll see. That means the seemingly high price tags that are often attached to quality stocks can prove fabulous bargains over the long term.

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There is good evidence from many big studies into quality investing that this style can beat the market over time, although not consistently.

One well-known study by award-winning academic Robert Novy-Marx looked at what would have happened between 1963 and 2010 to an investor that bought the highest-quality companies and bet against the lowest quality ones among the 500 largest US-listed companies.

He found the market-neutral strategy would have on average made his fictional investor 0.31% every month.

My own stock screen for quality shares, which I ran for Investors Chronicle magazine while I worked there between 2011 and 2021, and which we’ll look at in more detail shortly, produced outperformance of 388% over the decade I monitored it.

Stock screens work by highlighting shares in companies that display financial characteristics associated with a desired type of investment opportunity.

When it works

Historically, quality investing has tended to protect investors when economic conditions get tough but tends to underperform during recoveries.

That makes sense, because quality businesses should hold up better to tough trading conditions but have less to recover from when things improve.

As with all rules of thumb, though, this not always true. Quality investing became hugely popular during the 2010s. That pushed up valuations of some quality companies to extreme levels, and there were some painful share price falls when market conditions worsened in 2022 despite underlying trading at many of these companies remaining good.

Quality traps

Overpaying for a genuine quality company is one thing, but the worst trap quality investors can fall into is buying a company that produces the wrong kind of growth. That’s because expensive growth actually destroys value for shareholders. This is easy to overlook but vital to understand.

Take the example of a company that can borrow freely at a 5% interest rate to fund its growth. However, the profit this company makes from investing the money it borrows is only 3%. There is a 2% shortfall between what it earns and its borrowing costs.

For this company, any growth will only make its problems bigger.

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Growth companies that make returns that are less than the cost of investment are a very real problem. They are a problem for quality investors because most companies that fit this mould also tell very good stories about how profits will improve over time and reveal their true quality credentials.

Fortunately, investors in quality companies don’t need to speculate on the next big thing. The strategy works by focusing on companies already displaying the characteristics expected from a quality “compounder”.

Let’s find out what those characteristics are now.

Putting it all together

As we’ve already explored, crucial to the power of compounding is the ability of a company to make a high return from investing in its own business.

Investors have many ways to measure the returns companies make on investment. Some popular ones are return on capital employed (ROCE), return on invested capital (ROIC) and return on equity (RoE).

Looking for consistency is also important. Some companies have moments when they produce very high returns but then do very badly when the business cycle turns. The kind of sustainable competitive advantage a genuine quality company has should mean the returns it makes on investments are high come rain or shine.

Another thing we can check for is whether a company’s customers are prepared to pay up for what it is selling. This is reflected in a company’s ability to turn a large proportion of its sales into profit, meaning it has high margins.

Quality businesses can also sometimes have low margins but produce high returns by generating a reliably large amount of sales from money invested in the business. This is known as high asset turn.

When hunting for quality companies, asset turn can be a more nuanced signal than margins. That’s why the stock screen I ran for 10 years at Investors Chronicle focuses only on the latter.

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Based on annual portfolio reshuffles, this screen produced a total return over those 10 years of 508% compared with 120% from the FTSE All-Share index, which is the index it picked stocks from. Factoring notional fees of 1.5% a year, the return drops to 422%.

Despite the impressive numbers, screens like this should be used as a way of generating ideas for further research rather than to create off-the-shelf portfolios.

The FTSE All-Share stocks currently highlighted by the screen can be found below.

My book Four Ways to Beat the Market, published by Harriman House, provides more detail on how this screen works, how to research the ideas it highlights, and how to adapt criteria to cope with changing market conditions. It also covers three other market-beating strategies.

Here’s what the screen looks for, along with the FTSE All-Share stocks it is highlighting right now. I’ve also highlighted the tests I feel are core to the screen while the others can be relaxed to try to achieve more results.

A higher than median average (mid-ranking) return on equity (RoE) out of all stocks screened. CORE TEST

• Higher than median average operating margin. CORE TEST
• Operating margin growth over the past three years. 
• RoE growth over the past three years. 
• Higher than median average operating margin in each of the past three years. 
• Higher than median average RoE in each of the past three years. 
• Interest cover (operating profit to interest expenses) of five times or more. 
• Positive free cash flow. 
• Operating profit growth over the past three years. 
• Earnings growth forecast for each of the next two years. 
• Market cap over £1 billion. 

Only engineer IMI (LSE:IMI) passed all my screens tests. However, ten further stocks were able to pass both core tests and all but one of the screen's remaining criteria. All eleven stocks are presented in the table below.

Algy Hall is an award-winning journalist and author of Four Ways to Beat the Market which can be bought by ii readers from all good book shops including Amazon.