3 Quality Stocks for a Down Market

How soon we forget.

It has become blasphemy to speak of last year's fourth-quarter carnage or even the horrific first two months of this year. Yet to hear most investors tell it, we embarked on a new bull market on March 9, 2009 when the S&P 500 flirted with its 52-week low.

To hear them tell it, the economy is picking back up -- and taking the market right along with it -- and there's nowhere to go but up.

Or not.

Color me a skeptic. I don't think we're out of the woods yet -- which means I'm placing an even higher premium on quality these days.

See, it turns out that 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:

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

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

When the so-called green shoots begin firing blanks, it will be the high-quality stocks that will outperform -- in up and down markets alike.

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

What is "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 tomorrow's multibaggers 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 shortsighted decisions, and shirk responsibility when confronted. One of the characteristics we watch closely is the level of inside ownership. This isn't always a telltale 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 here 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 Coca-Cola (NYSE:KO), Intel (NASDAQ:INTC), and IBM (NYSE:IBM) 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 Costco (NASDAQ:COST) 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 30%, and revenue that has held up during the most recent four quarters.

Data from Capital IQ, a division of Standard & Poor's. CFO = cash from operations; CAGR = compound annual growth rate; LTM = last 12 months.

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 Microsoft, Nike, or Google, and we are currently following some companies with that type of long-term 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 -- there's no obligation to subscribe.

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This article was originally published April 15, 2009. It has been updated.

Keith Beverly owns none of the stocks mentioned in this article. Costco, Intel, and Coca-Cola are Motley Fool Inside Value recommendations. Coca-Cola is an Income Investor choice. Costco is a Stock Advisor pick. The Motley Fool owns shares of Costco and has a disclosure policy.