A five-step process for finding quality stocks

It’s widely accepted that if you’re after a premium offering, you’ll need to pay top dollar. This doesn’t deter Michelle Lopez and the team at Aberdeen Standard Investments for hunting out the highest quality stocks, and she reckons the market can often overlook their potential.

“The market often systematically under appreciates the returns from high-quality companies.”

Lopez says this is because the best companies have fewer tail risks, generate more sustainable earnings and are positioned to capitalise on opportunities in distressed markets. The term ‘quality is widely used and can mean different things to different people. Lopez says that she is crystal clear on what constitutes a quality company and breaks it down into five steps. 

In this short video, she explains each of the hurdles that need to be cleared to pass Aberdeen’s quality filter.

Click on the player to watch the interview or read an edited transcript below.

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Edited transcript

Michelle Lopez:

Perhaps it's worth taking a step back and why we believe quality investing works. Really it comes back to the fact that the market often systematically under-appreciates the returns from high-quality companies. So, when you think about high-quality companies, they have fewer tail risks and they have much more sustainable and predictable earnings profiles. The other side of it is that they're able to take advantage of opportunities in markets because they are more conservative. So, when the opportunity arises, they can be more aggressive from that point of view. So that's why we believe it works and we've proven it works through the performance of the funds.

I appreciate quality can be quite an obvious term in our industry. For us, we're very clear about what it means, and we've got a very clear framework around it. I tend to think about it in five levels. The first is the industry structure. So we're looking for, what are the barriers to entry within an industry? Who are the players? Who's got the market share? Is it ripe for disruption? Is it not?

The second thing is the business strategy itself. So how is this company playing into that industry? Are they the disruptor? Are they being disrupted? Do they have the market share?

Then we look at the management team. And are the right people in place to execute on that strategy? So, we look at things such as track record, what they've done in previous roles and their alignment.

The fourth thing is financials. So, we spend an inordinate amount of time dredging through financial statements and really understanding the risks around the financials. We've always, not just in the current situation, brought off-balance sheet liabilities back on balance sheet because they are liabilities at the end of the day. We look at cashflow, probably in a lot more detail than we do earnings.

And then the final pillar to our quality filter is ESG. So, we embed ESG across the entire investment decision-making process. So, from idea generation, through to research, through the portfolio construction, it's there at every level.

So that's kind of the way we think about quality.

Another way to think about it is we look for the mispricing in quality and that's the quality of earnings, assets, and franchise. So, if I think about assets, what are the assets of the business? It's the ability of fixed assets, intangible assets, management teams, customer relationships, to generate a return. If I consider earnings, what is the quality of the cashflow generation? Is it lumpy or is it quite sustainable? And then the earnings power over the long-term. And the third thing is the franchise itself. So, is there a moat? Are there barriers to the business, which means that the return on invested capital can be higher for a longer period of time. 

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Michelle and her team search for quality companies that are being underappreciated by the market. You can stay up to date with all of her latest content by hitting the follow button here.