We live in curious times. While now is the least violent period of modern human history, we often seem to be teetering on the brink of something awful. Terrorism, climate change, political upheaval, 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 a 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 the heavily patented Botox. (Allergan was bought by AbbVie in 2020.)
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. By June 2004, its total market value was around $500 million, while its debt level was a whopping $1.1 billion. By 2005, the stock had fallen to $0.1 per share. Today, nearly all 9,000 Blockbuster stores are gone.
Now consider Procter and Gamble. P&G is deeply entrenched in the global economy and, in 2019, generated over $67 billion in revenue from about 70 core brands including Bounty, Charmin, Crest, Dawn, and Gillette. 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 has also pays an annual dividend.
These qualities don’t mean P&G’s stock price doesn’t fluctuate, but it's easy to sleep better at night knowing these facts about the 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.