Investing is a delicate process that takes many different factors into account. The main goal in investing, however, is to pick the right stock, which is easier said than done. For example, if you were tasked with picking between car manufacturer General Motor’s (GM) stock and aftermarket car parts O’Reilly Auto Parts (ORLY) stock in 2013, the “high growth”, cheaper, All-American GM pick might have seemed more attractive than ORLY, which was more expensive and had slow, steady growth. The reality, however, is that O’Reilly’s shares have grown 327% since 2013, while GM’s shares have only grown 44%. The Implication? O’Reilly was a high-quality stock, while GM was not.
Choosing high-quality stocks can be difficult, as they are often hidden in plain sight due to the fact that they are neither “growth” nor “value” stocks, categories often attributed to success in the investing landscape.
How then, can we define these high-quality stocks? By taking two factors into consideration: profitability and consistency.
It is profitability, rather than growth, which determines a high-quality stock. Fast-growing companies can be profitable in the short term, but these gains can be deceiving and often leave investors unsatisfied when the company turns out to be unprofitable in the long term.
Profitability is most easily determined by a company’s operating margins. Revisiting our car example above, GM’s operating margins in 2013 were only 2.5%, while O’Reilly’s operating margins were much higher at 15%. O’Reilly’s high margins can be attributed to its position within the “big four” of aftermarket automotive parts. GM on the other hand is just one player within an industry containing dozens of car manufacturers, and its lower profitability clearly reflects this.
Another method of determining stock profitability is by examining a company’s return on invested capital (ROIC). ROIC is a great way to predict a stock’s ability to compound as it allows investors to understand the rate at which a company generates returns based on total debt and equity given by investors. For context, GM’s ROIC in 2013 was 6%, while O’Reilly’s was 22%: almost 4 times the rate of GM. This ultimately means that O’Reilly has more cash on hand to grow its business and reinvest.
The second factor which defines high-quality stocks is consistency, which is sometimes overlooked in favor of “high-value” stocks. For O’Reilly, which sells aftermarket car parts, the demand for such parts is fairly consistent regardless of economic conditions – e.i. cars will continue to break down no matter what. In the investing world, consistency leads to stability, allowing investors to hold on to their ORLY stocks for long periods of time with relatively low worry. Furthermore, this stability gives investors much more freedom and flexibility when it comes to selling decisions and tax rates. For example, investors that hold onto high-quality stocks can wait until they retire to sell the stock, resulting in them paying lower capital gains tax within a lower tax bracket.
Furthermore, with stocks that participate in buybacks, such as O’Reilly, investors can choose to donate their shares to charity, or even hold their shares until death. Both of these circumvent the need to pay taxes on the investment and can be highly beneficial to investors.
To summarize, by combining profitability and consistency factors with patience, investors have the best opportunity to compound their wealth over the long term. While these factors may seem boring or obvious, taking them into account when choosing a stock can have incredible results, as seen with our example of O’Reilly and GM. Adding diversified high-quality stocks to one’s portfolio is the basis for achieving maximized long-term returns, and should under no circumstance be overlooked.