Screening For High-Quality Stocks With Superior Profitability

Investing in high-quality stocks can be a great strategy to obtain superior returns over the long term. Few investors would disagree with that statement. However, implementation is the key part. Quality can be defined in multiple ways, and finding high-quality stocks is much easier said than done.

Nevertheless, business quality can also be measured through financial indicators and profitability ratios, and superior profitability over the long term is many times a sign of superior fundamental quality too.

Success attracts competitive pressure in the business world. When a company is doing well in a particular market, chances are that the competition will try to intensify the pressure to steal some of those profits. Only the companies with superior fundamental quality and competitive strengths can sustain above-average profitability levels over long periods of time.

The following screener looks for companies with superior profitability across the board by relying on metrics like operating profit margins, return on equity, and return on investment. The main idea is focusing on different kinds of profitability metrics in order to find companies with consistently superior quality across different indicators.

Strategy Design

To begin with, the screener considers only companies with a market capitalization value above $250 million. This requirement has a negative impact on returns because many times the small companies are the ones that deliver the bigger gains. However, it makes sense to guarantee a minimum size for inclusion in the screen due to risk and liquidity considerations.

After that, the screener measures companies based on 3 different profitability ratios: operating profit margin, return on equity, and return on investment. The average value for the three ratios needs to be above zero over the past five years and also above the industry average.

Operating profit margins measure profits at the operating level as a percentage of revenue. Companies that can retain a larger share of revenue as operating profit can obviously generate more value for shareholders over time. Besides, high operating margins make a company more resilient and more capable of withstanding economic headwinds.

Return on equity reflects management's ability to translate each dollar in shareholder equity into net income. The higher the return on equity, the higher the value of that equity, and companies that can generate high ROEs over the long term can produce accumulate compounded profits at an impressive speed.

The main drawback of ROE is that it can be affected by financing decisions such as financial leverage. Companies that issue debt can generate a higher return on equity than those with more conservative debt levels. This is not necessarily a bad thing, and sometimes issuing low-cost debt is, in fact, the smart thing to do. However, financial leverage also increases the risk for investors.

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Disclaimer: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in ...

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