How I find quality growth stocks

Owning high-quality stocks has delivered great returns for investors over the years. Paul Summers explains how he’s using this strategy in his own portfolio.

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Owning a diversified portfolio remains a priority for me. Even so, I can’t deny I’ve a preference for quality growth stocks.

Today, I’ll explain how I go about investing in them.

Diamonds in the rough

What do I mean by ‘quality’? Well, that’s always going to be subjective. Ask 10 Fools and you’ll probably get 10 Foolish answers. Personally, I look for:

  • A competitive advantage (eg brands)
  • Low/no debt
  • Big margins
  • Higher-than-average returns on capital
  • A history of regular and rising dividends

An example of a stock I think fits this criteria is FTSE 250-listed Games Workshop (LSE: GAW).

The firm is a leader in a niche market and benefits from a fanatical following with deep pockets. It has net cash on its balance sheet, operating margins of around 35%, and returns on capital employed of around 60%. It regularly hikes its dividends too.

This is not to say that its share price can’t tumble. Indeed, owners would have seen their stakes roughly halve in value between September 2021 and September 2022.

For me, this just comes with the territory of investing. But this volatility won’t suit everyone.

An alternative strategy

There is an easier way of investing quality stocks, namely let someone else do it on my behalf.

One name that springs to mind is manager Terry Smith. By the end of March 2024, Smith had delivered an annualised return of 15.8% since setting up Fundsmith Equity in 2010. Compare that to its benchmark (MSCI World Index) of 12% and you can see why he’s so popular. It doesn’t sound like a big difference, but it is when compounded over many years.

That said, even Smith has underperformed in recent years, due to his avoidance of tech juggernauts like Nvidia. And, naturally, he’s charged a (not-insignificant) fee along the way.

Speaking of cost…

Going passive

A cheaper option is to use an exchange-traded fund (ETF). An example is the iShares Edge MSCI World Quality Factor. As it sounds, this is a passive fund. This means the portfolio’s run according to pre-set rules rather than the whim of a human manager.

Not that this should be seen as a limitation. Anyone buying at the peak of panic in March 2020 would now have doubled their money. By comparison, the FTSE 100 index has delivered a return of 54% (excluding dividends).

A further benefit is that my money’s spread across almost 300 companies. Smith’s fund has just 28 holdings, arguably making it a far riskier proposition. Then again, holders outperform when his picks do well.

No guarantees

Personally, I use all three approaches detailed above. I have money invested with a select band of professional money managers (Smith included) and another pot of cash in passive funds with a quality bent. And because I find the challenge of picking stocks intellectually stimulating (not to mention occasionally lucrative), I own a few single company shares that neither of the above do.

Of course, buying quality growth stocks will not make me rich overnight. No strategy will do this. And anything that does sounds more like gambling to me.

But owning the best the market has to offer for as long as possible feels like something I can stick to. And isn’t that the point?

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Paul Summers owns shares in Games Workshop Group Plc, Fundsmith Equity Fund and iShares Edge MSCI World Quality Factor UCITS ETF. The Motley Fool UK has recommended Games Workshop Group Plc and Nvidia. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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