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GMO Asset Management is a firm that manages $61B in capital. It’s been actively picking stocks in its GMO Quality Fund for ten years, and it has managed to beat the market in every single year of the last decade with an annualized return of 13.4%, beating the S&P 500 quite nicely.
In a world where most stock-pickers either lose money or underperform the overall market, consistently beating the market is rare.
The good news is that the team behind this high-quality, active investment fund has just launched an ETF we all can invest in with whatever amount of money we want to.
In today’s post, I dig into the fund’s stock-picking strategy that has beaten the market for a decade and give you a list of stocks based on the fund’s market-beating strategy that you can consider buying now.
Let’s talk about them!
I'm Hoda Mehr, founder, and CEO of Stock Card, and on this blog and its accompanying YouTube channel and Podcast show, I share detailed fundamental analyses and interesting investment stories.
This post is part of our educational series to help you hone your fundamental investing skills. Catch up with past blog posts on How to Invest Like Buffett? How to Invest Like Charlie Munger, or how to Find the Highest-Returning Stocks?
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Quality Investing Isn't Value Investing
The methodology behind GMO’s fantastic return is investing in quality companies at a reasonable price. This may sound familiar to many, but how GMOs define “quality” is very interesting. Also, the ways the fund managers explain “reasonable stock price” is fascinating.
When you hear the term reasonable price, it's natural to think of undervalued stocks with low multiples, such as low price-to-earnings ratio or low price-to-book value ratio. GMO’s partner, Tom Hancock, explains the difference between quality and low-value stocks with a perfect analogy:
Quality and value investing are very different approaches. Quality doesn’t always mean paying a low price and picking a low price to earn earnings or price book value multiples. Quality investing is like when you buy a bit more expensive house in a good neighborhood with good schools around and can sell the house at a great return a few years down the road, vs. buying a cheap condo in a not-so-good neighborhood, hoping for an up-an-coming investment opportunity which doesn't happen as fast as you had hoped.
An even more insightful thing I learned when researching this investment strategy is that investing in quality defies all the commonly accepted logic about risk and return. Everybody says higher return requires higher risk. In practice, investing in high-quality businesses leads to less risk in the form of less price fall during a downturn and several sustained years of generating better-than-market returns.
This becomes quite clear when we define risk as the probability of a permanent loss of capital. With that definition of risk, investing in high-quality companies has less risk because the business isn’t as prone to market noise and macroeconomic cycles.
What's A High-Quality Stock?
Quality is the ability to deliver high return on capital. To deliver that you have to have something competitors can’t replicate. It used to be a physical asset or brand. In the tech era, it is network effect or platform companies. Management quality is also a part of the company’s overall quality. Good management keeps the balance sheet strong to create stability across economic cycles and allocates money when required.
The good news for stock-pickers who want to focus on quality companies is that they tend to stay high quality for a long time. Therefore, you don’t have to recognize them right off the bat. You can be wrong early on and ignore the stock; when you see the evidence, you can turn 180 degrees, admit it, and invest in it. For example Apple is a quality company and both GMO and Warren Buffett were late to Apple’s quality party and their eventual investment still did great. Even though Warren Buffett didn't invest in Apple’s IPO or the dot com crash. Still, it turned out to be one of its best investments ever.
How To Find Quality Stocks
There are two ways to find quality stocks based on GMO's definition of quality we just discussed:
In the rest of the post, I’ll use both methodologies to find quality stocks at a reasonable price that you may want to invest in after doing your own research, of course.
First, let’s discuss the financial metrics we can use to find quality stocks. Tom Hancock gave a few such metrics in my research. Let me summarize them for you:
I plugged these criteria into Stock Card’s stock screener tool, and I got about 100 stocks that turned in the screener results. Here's the link to this screener if you want to download the list or adjust the screener. But think about it! Of thousands of stocks listed in the US, only 100 meet the criteria. Also, because we are using return on capital, return on asset, and similar return ratios in the screener, there are a lot of bank stocks showing up in the results. I tend to put them aside. Without bank stocks, you’ll end up with an even smaller number of stocks that meet the criteria.
Some interesting companies that attracted my eye are Alphabet, Applied Materials, and Dropbox.
QLTY ETF's Top Holdings
Now, let’s turn to the second approach of finding high-quality stocks at reasonable prices by looking at the top holdings of GMO’s new quality ETF. The ETF’s ticker is QLTY, which is very well-named. Because the ETF is less than a year old, it’s fair to assume stocks picked for the ETFs are still truly representative of GMO’s reasonable price picks. On the list, I see some of the usual quality stocks such as Alphabet, Apple, and Meta. I also see some names that i wouldn’t have normally paid any attention to me. Otis, ticker OTIS, the big leader in elevators, escalators, and moving walkways, is one example. Elevance Health, ticker ELV, is another one I have not heard much about. TJ Maxx, ticker TJX, would be my third pick to research just because I have always wanted to look into it but never did.
You notice that stocks such as NVIDIA weren’t in the top holdings of the ETF. NVDA is definitely a high-quality company but may not be reasonably priced even if it is the undisputed kind of AI semiconductor market.
Talking about high-quality stocks tending to be low-risk stock picks, a post I published recently explained what risk means and how you can calculate your portfolio’s risk. That’s a good one to read to next.
I’ll see you next time!