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.

We now live in a world of green shoots, where "less bad" is the new "good," and markets are destined to go up -- forever.

Or not.

Color me a skeptic. I don't think we're out of the woods yet -- so 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 by 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 gave up during the period.

When those 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're 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 gray 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 such as Kraft (NYSE:KFT), Yahoo! (NASDAQ:YHOO), and Johnson & Johnson (NYSE:JNJ) 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 and services. Strong brands help to insulate companies during a weak economy, like the one we face today. Netflix (NASDAQ:NFLX), a company with a relatively short history compared with the above three, has revolutionized the video industry and put serious pressure on its competitors to reinvent themselves.

Where you can find quality
There are no quick and easy ways to identify quality, but I have pulled a few metrics that I used 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.

Because these companies are among the entrenched leaders in their respective industries, they have an upper hand on continuing 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. They're focused on finding the next Johnson & Johnson or Netflix and are currently following some companies with that type of long-term potential. They 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 their 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.

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

Keith Beverly doesn't own shares of any companies mentioned in this article. Netflix is a Stock Advisor pick. Johnson & Johnson is an Income Investor selection. Sohu is a Rule Breakers recommendation. The Fool owns shares of Kinetic Concepts and has a disclosure policy.