In investing, quality comes first

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When you think of companies with stable, predictable earnings and low debt levels you might just nod off. Where are the great stories, the risks that can lead to huge gains and the potential to dazzle your friends?

Well, wake up: If your goal is to make money, so-called quality stocks are likely the most rewarding investments you can make. And the best part is that the market doesn't seem to recognize their virtue.

"Investors systematically undervalue the unexciting stability of Quality stocks except during times of financial crisis," said Chuck Joyce and Kimball Mayer, in a note from global asset manager GMO.

This isn't a safety-comes-first argument. Instead, Mr. Joyce and Mr. Mayer argue that low-risk stocks with exceptional profitability and low debt levels generate strong returns – inverting the standard approach to investing, which argues that you have to take big risks to generate strong returns.

Among the 1,000 largest U.S. companies, those with low debt levels have enjoyed an average profit margin that is 5 per cent higher than companies with high debt levels, for data going back to 1965.

What's more, companies that are highly profitable tend to stay highly profitable, driven by strong branding, franchise value and intellectual capital – all of which build a moat around a company and protects its profitability from heel-snapping competitors.

And no, these companies don't have to be global mega-caps. The GMO authors point to candy-maker Tootsie Roll Industries Inc. and industrial-lubricant maker WD-40 Company as oligopolies that are able to maintain exceptional profitability in an ever-shifting corporate landscape.

"Chances are you can immediately picture the candy wrapper and conjure up the distinct smell of the spray. Each of these companies has huge brand recognition and the profitability to match. While antitrust laws prevent monopolies from engaging in blatant anti-competitive behavior, oligopolies can and do create barriers to shield themselves legally from competitive forces."

What does this mean for share price performance? Tootsie Roll shares have been struggling while WD-40 shares have been hitting record highs recently, but the broader picture is more telling.

The authors found that since 1965 quality U.S. stocks with low debt, high profitability and stable earnings outperformed the market by an average of 0.7 per cent a year. Low-quality stocks – high debt, low profitability and volatile earnings – underperformed by an average of 1.7 per cent a year.

These gains might appear small, but they become very significant over time.

The differences are even more pronounced outside the U.S. market, with quality stocks outperforming the MSCI EAFE index (Europe, Australasia and the Far East) by a dazzling 2.2 per cent a year, for data going back to 1985.

Despite this outperformance by quality stocks, the market doesn't seem to care much about them – but that is their big advantage.

"Their predictably higher profits are not quite high enough to command the attention of a market in thrall to the possibility of the next big jackpot," Mr. Joyce and Mr. Mayer said. "This has led to the systematic undervaluation of Quality stocks, which leads to their systematically higher returns over the long term."