When share prices move at the whim of macroeconomic events or monetary policy decisions, it can be easy to forget what makes a quality company, or where to find such businesses. One simple starting point remains the US equity market. Its sheer size and depth, coupled with its reputation as the home of many of the world's most innovative and entrepreneurial businesses, make it a prime breeding ground for quality shares.
Further qualifications are sometimes of use: in 2021, the first year we highlighted four US companies of this ilk in this annual feature, we opted to look “Beyond the Faangs”, ie away from the well-covered large-cap technology stocks. Last year, by contrast, we included Microsoft (US:MSFT), partly to illustrate how it acts as an exemplar of a quality growth stock. That proved to be a wise choice, given the shares’ 55 per cent rise over the intervening 12 months, with the driver of a decent portion of these returns being the rise of artificial intelligence (AI).
At the same time, Microsoft’s success over the past year does emphasise its quality credentials. As a highly profitable business, it has resources (and the cash) to redirect into new ventures that provide new avenues for growth, as the AI boom has aptly demonstrated. And while management upheaval at OpenAI last weekend may jeopardise the value of Microsoft’s 49 per cent stake in the business, the initial outcome arguably spoke to the nous of Satya Nadella and the rest of Microsoft’s management: they have secured for themselves the services of erstwhile OpenAI chief executive and AI figurehead Sam Altman, only to revert to the existing arrangement as the dust settled.
Not all quality companies accrue returns so rapidly. US stocks free from AI fervour have performed in a relatively pedestrian fashion in 2023, and that was true of two of our other picks last year, software company Paychex (US:PAYX) and railroad CSX (US:CSX). The fourth, medical instrument maker Waters Corporation (US:WAT), struggled more notably due to underwhelming performance in China and a post-pandemic slowdown in overall sales growth. Terry Smith’s Fundsmith Equity fund (GB00B4Q5X527) is a notable holder of the shares; the manager said this summer that he was “not bothered” by its struggles and would look for an opportunity to add more to his position. In many ways, this too underlines the attributes of the companies selected by our screen: as quality compounders, they are designed to be held over many years, during which time the benefits of their substantial returns on investment, and ability to reinvest that money back into new growth opportunities, become increasingly apparent.
It’s in some ways counter-intuitive, therefore, that we refresh the screen each year in a bid to uncover more shares with these same qualities. All the same time, this approach has served us well so far: as the chart outlines, the 4.3 per cent sterling total return from the US quality picks over the past year, while lower than the S&P 500’s 11 per cent return, is more than enough to maintain the screen’s advantage since its advent two years ago.
Read our in-depth analysis of the top four companies from the screen below
