written by: Jason C. Chavis•edited by: Rebecca Scudder•updated: 6/29/2011
By understanding the fundamentals of quality investing, one can choose the best in stocks and bonds with a higher likelihood of a better return. The strategy of quality investing can help you choose the best value in securities.
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The concept of Quality Investing is a strategy that enables an investor to identify financial opportunities that supply an above average rate of return. Originating within the real estate and bond markets, investments were judged by both the price and overall potential. This was done using a variety of rating and expert insight. In order to implement the practice with equities, an investor is in need of performing a fundamental analysis of the security. Basically, financial statements are analyzed, as are the management and competitors. The overall position and health of the security are determined by the marketplace. This helps the investor make a quality choice when picking stocks. A Quality Investor should invest only in financial vehicles which are highly valued and pass the testing to determine if it is indeed a Quality Investment.
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Origins of Quality Investing
Benjamin Graham determined the trouble with investing in 1930s was that it was hard to make a good choice based on quality and value. He created the two strategies of Quality Investing and Value Investing. In terms of measurement, Graham found that financial vehicles were either Quality or Low Quality. This philosophy showed that losses stem from the purchase of Low Quality securities at a reasonable price rather than Quality securities at a high price.
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Classifying investment instruments according to their quality has long been a tradition of the bond market. A ratings system is used to help determine creditworthiness of a borrower. This makes the corporate and public sector bond market easily adapted into the paradigm of Quality Investing. Bonds are separated into two types: investment grade and junk bonds.
With investment grade bonds, a credit rating is determined by different companies. If the bond is rated BBB- or higher by Standard and Poor's, Baa3 or higher by Moody's or BBB(low) or higher by the Dominion Bond Rating Service, it is considered a Quality Investment. Anything else is considered a speculative grade investment or junk bond.
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Enterprise Life Cycle
Following the development of the Boston Consulting Group matrix in 1970, Quality Investing became much more efficient. Understanding the concept of the enterprise life cycle as well as the learning curve effect could make an investor understand whether the vehicle was Quality or Low Quality. The enterprise life cycle was the fundamental understanding that a company needed to develop new products and implement new technology, while at the same time disposing of old products and technology. The learning curve was basically how fast it took a company to go through this cycle. By using the Boston Consulting Group matrix, an investor could determine where on this cycle the company was and what the overall benefit of the investment may be.
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Types of Strategies to Maximize Returns
Two types of Quality investments have been identified: Cash Cows and Stars. In addition, two Low Quality types of investments have been found: Question Marks and Dogs. Cash Cows are those financial assets with the greatest potential to continue paying out. Stars would be ones that may drift up and down, but generally maintain a good value. Question Marks are long shot opportunities that may or may not pay off. Dogs are downright terrible stocks and should be completely avoided.