What Makes A Stock A 'Quality' Stock?

Investors pick stocks for a nearly-infinite number of reasons to achieve their investing objectives.

Some people look for value stocks, or stocks that are perceived to be undervalued compared to their peers. Others look to growth stocks, or stocks that are due for future growth. Others still may look for income or yield stocks that will provide income via dividends.

But there’s a fourth category of stocks, popularized by investor and “Shark Tank” star Kevin O’Leary. He invests in “quality” stocks and has helped launch ETFs that do the same, like the O'Shares FTSE U.S. Quality Dividend ETF OUSA. But what makes a stock a “quality” stock?

For starters, quality stocks will grow consistently over long periods of time, deliver dividends, and have favorable balance sheets. In particular, quality stocks have consistent profitability and low leverage.

Popping On Profits

The first rule of business applies to stock picking—the company has to make a profit. Companies that are able to generate more profits for themselves have a higher potential in generating higher returns for their investors.

This seems elementary, but big-name Wall Street darling stocks like Amazon.com, Inc. AMZN, Tesla Motors Inc TSLA and other tech names either rarely or never turn profits. While these companies are potentially valuable investments, investors with a long-term horizon should avoid betting that a company will turn profitable in the future. There’s no guarantee this will ever happen.

Profitability has a few components, as well. Investors looking for quality stocks should make sure these companies have a track record of being able to consistently grow their earnings over time.

Long-term investors should also be looking for cash profits, not profits derived from accruals like depreciation. Avoid companies reporting IOUs as profits, either. In the words of Biggie Smalls—credit? Forget it.

Lose The Leverage

The other side of the quality coin is the debt the company carries. Leverage is a measure of the company’s debt load and its ability to meet its interest obligations. In the simplest terms, a company’s leverage ratio is a measure of its cash flow to total debt.

Companies that are able to regularly pay their creditors are like borrowers with good credit history—you can reasonably expect you’ll get your money back and then some. If companies are struggling to pay down debts, they aren’t good long-term homes for your money.

Quality stocks are meant for people who are looking for safety in the equities markets. These stocks are not resistant to drawdowns—no stocks are immune to that—but the characteristics of their balance sheets makes them good long-term investments.

As the shark himself says, 'You will never go broke, making a profit'. Investing in stocks and ETFs that are built on these characteristics could help you live up to that.

O’Shares Investments is an editorial partner of Benzinga. We collaborate on stories that are educational, or that we think you will find interesting.