3 Quality Stocks for a Down Market

During average or down markets, finding quality is not only preferred, it is essential. Last year was painful, and I won't recap the horror. But it was a lot worse for those who did not own quality stocks than for those that did.

Difficult markets are particularly tough for low-quality stocks. Check out this table, which depicts the performance of stocks grouped by their S&P quality ratings from the beginning of 2008 to last December:

 Quality Rating

Return

A+

(30%)

A

(40%)

A-

(45%)

B+

(45%)

B

(50%)

B-

(60%)

C

(75%)

*Data courtesy of Hussman Funds. Returns rounded to nearest 5%.

Granted, being down 40% is a disastrous outcome by any measure. However, I am sure you'd rather lose 40% than the 75% that the lowest quality stocks lost during the period.

And given the rocky economic environment we now face, it's reasonable to expect high-quality stocks to continue outperforming as the market rebounds.

All of this raises two questions. How do you define quality? And, where can you find quality?

What's “quality”?
Standard & Poor's defines quality based on a number of factors, including size, leverage, growth, profitability, and dividends. Our team at Motley Fool Hidden Gems believes that high-quality stocks also have a quality management team, quality earnings, and a quality business.

Here's why:

More often than not, poor management will lead a company down an underperforming path. They feign competence, make short-sighted decisions, and shirk responsibility when confronted. One of the characteristics we watch closely is the level of inside ownership. This isn't always a tell-tale sign that we are dealing with a quality management team, but it at least signals that their interests are aligned with ours.

Despite legislation such as the Sarbanes-Oxley Act, which is designed to deter deceptive accounting practices, some companies continue to mislead investors. Accounting standards have numerous grey areas that unscrupulous executives massage to get their mitts on more of your hard-earned money. It's not a hard-and-fast rule, but it is one possible red flag that can tip you off to this type of manipulation -- a significant divergence between cash flow from operations and net income where net income growth far exceeds cash flow growth.

Quality businesses usually have compelling brands and/or a discernible competitive advantage. Household names like Apple (Nasdaq: AAPL  ) , General Electric (NYSE: GE  ) , and Starbucks (Nasdaq: SBUX  ) all began out of relative obscurity. It took years for all of these companies to cultivate their brands and establish wide appeal for their products. Strong brands help to insulate companies during a weak economy like the one we face today. Low-cost producers like Wal-Mart (NYSE: WMT  ) maintain their edge by being the cheapest store in town.

Where you can find quality
There are no quick and easy ways to identify quality, but I have pulled a few metrics that I use as an analyst with our Motley Fool Hidden Gems investing service to get you started. The chart below includes companies that all have at least 10% insider ownership, net income that does not outpace cash flow by more than 25%, and revenue that has held up during the most recent four quarters.       

Company Name

Insider Ownership

5-Yr. CFO CAGR

5-Yr. Net Income CAGR

LTM Revenue Growth

Oracle (Nasdaq: ORCL  )

23%

23%

18%

12%

eBay (Nasdaq: EBAY  )

15%

27%

32%

11%

ArcelorMittal (NYSE: MT  )

46%

59%

51%

19%

All of these companies are among the entrenched leaders in their respective industries, which should help them continue to generate revenue, even in this environment. Moreover, they boast strong earnings quality and high levels of insider ownership.

If you demand these characteristics from all of the companies in your portfolio, you will own stable companies not easily swayed by economic winds.

Another great place to find quality companies is our Motley Fool Hidden Gems investment service. We're focused on finding the next Apple, eBay, or Starbucks, and we are currently following some companies with that type of potential. We strictly recommend small-cap companies with no-nonsense management teams, strong cash-flow generation, and businesses built to grow for years and years to come.

If you're looking for additional stock ideas, you can read about our favorite high-quality stocks with a free 30-day guest pass to Hidden Gems. Click here to get started.

Keith Beverly does not own shares of any company mentioned. Apple, eBay, and Starbucks are Stock Advisor recommendations. eBay, Starbucks, and Wal-Mart are Inside Value selections. The Motley Fool owns shares of Starbucks. The Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (71)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 15, 2009, at 4:48 PM, BellasPosting wrote:

    Yet another article recommending eBay! ENOUGH! We know you guys love eBay. Why is a mystery to me, but you seem to hype them ALL the time, especially right before their earnings report. EBay has NO core growth, period. They tried to become Amazon and failed miserably. Get over eBay, guys. They are a dinosaur.

  • Report this Comment On April 15, 2009, at 6:36 PM, evelynel wrote:

    I have been watching the Motley Fool and the various comments. I agree that they seem to peddle the same thing over and over again.

    EBAY is deader than a doornail, they are spinning off Skype, and many of their claims are false, they do sell a lot of fake merchandise and seconds. Not a good company I have removed myself of their data base

  • Report this Comment On April 15, 2009, at 10:42 PM, smaulcap wrote:

    I agree with the above comments regarding eBay. Right now, eBay doesn't know which end is up. Ebay seems to be lost and searching. Searching for what? eBay doesn't know what. eBay shmeeBay.

  • Report this Comment On April 16, 2009, at 7:53 PM, BellasPosting wrote:

    The Fool is also pulling posts I made about eBay on another thread. I'm starting to wonder if there's something fishy going on here...

  • Report this Comment On April 20, 2009, at 11:25 AM, Frijsenborg wrote:

    MT is down by 13% this morning. At what price would it be reasonable to buy?

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