What Do Quality Stocks and Bonds Mean?
Keep Your Financial and Emotional Equilibrium in Tumultuous Times
These are curious days. The world overall has never been healthier, wealthier, or wiser. Technology has made the stuff of science fiction a mundane part of everyday life. And while the evening news may leave a different impression, this is the least violent period of modern human history.
At the same time, we often seem to be teetering on the brink of something awful. Terrorism, climate change, political upheaval (by gun or ballot), and the lingering effects of the Great Recession can make us feel we’re on a torturous roller coaster ride to, well, somewhere bad.
World events have a significant effect on the financial markets, which recoil at even a whiff of uncertainty. So, it’s understandable that clients often ask how they can maintain their financial and emotional equilibrium in these tumultuous times. The answer: Own quality stocks and bonds that produce income. It’s that simple.
But what does "quality" really mean?
A Diversified Income Stream
A diversified income stream means that the company isn’t a “one-trick pony” and ideally has multiple lines of business selling into many different industries or consumer wants and needs.
Consider whether the company has a wide “moat” defending its business and keeping competitors at bay. Brand loyalty, patents, and/or unique products create moats. A high degree of difficulty required to switch away from the company’s products or services to a competitor’s offering also provides a moat. Apple has a wide moat, as does Allergan, the maker of heavily patented Botox.
A Wall Street analyst would refer to this as having relatively low and serviceable net debt. This simply means they have no problem paying their bills and haven’t overextended themselves with debt.
There are several metrics that measure profitability, namely net income and free cash flow. Yes, earnings are important, but they can be manipulated for any number of reasons, such as to impress Wall Street or lower a tax bill. Not so with cash. We know exactly how much the company has on hand, and the more the better. Available cash allows firms to weather storms and take advantage of opportunities.
So, let’s take a look at two companies and see how they measure up for “quality.”
Remember Blockbuster? The video rental chain was a one-trick pony that borrowed too much money. In late 2004, its total market value was around $1 billion, while its debt level was a whopping $1.3 billion. By 2010, the stock had essentially fallen to zero. Today, nearly all 9,000 Blockbuster stores are gone.
Now consider Procter and Gamble. P&G is deeply entrenched in the global economy and generates over $65 billion in revenue from about 70 core brands including Bounty, Charmin, Crest, Dawn, and Gillette. Their massive consumer product line is actually smaller (as of 2017) than in years past but more focused on their most profitable brands. Large divestitures include Duracell, Folgers, Crisco, Pringles, and Noxzema to name a few. Despite these changes, the company generates 20 times the cash flow required to service its debt and also pays an annual dividend north of 3 percent.
These qualities don’t mean P&G’s stock price doesn’t fluctuate, but I do sleep better at night knowing these facts about their business.
P&G is just one example of a company that checks all three of these quality boxes. It isn't necessarily a stock you have to own or even want to own, but using these basic criteria as a guide helps provide the resolve to feel comfortable about owning it regardless of how the stock market is doing.