In investing, quality not only can keep you out of trouble, but it can improve the returns you achieve as well.
Some investors look to make a fast buck by buying turnaround stories—companies that have fallen on hard times but have a decent chance to make a comeback. However, some of the most successful long-term investors, such as Benjamin Graham and Warren Buffett, have looked to quality companies to build portfolios of long-term investments. Warren Buffett’s mentor and the father of value investing Benjamin Graham said, “For the vast majority of common stocks, the average relationship between price and earnings will reflect the quality and growth of the issue.” In investing, quality means consistency, strength, and growth, as well as those intangible measures that you simply know when you see them. Fortunately, most of the characteristics of financial quality are quantifiable, so you can rate company quality to improve your portfolio and increase your investment success.
Benjamin Graham believed that growth and quality drive price and earnings. From that, he asserted that quality growth companies sell at higher P/E ratios than those of lower quality and slower growth rates. The following measures summarize the elements Graham considered to be influences on P/E ratios [Hack #27] and therefore signs of quality:
Strong historical sales and EPS growth [Hack #26] that compares favorably to the growth rates of competitors