The secrets to success that Microsoft, Meta, Lilly and Texas Instruments all share

By Michael Brush

The fundamentals of high-quality stocks, from a fund manager who handily beats the market

Everybody wants to own high-quality stocks, especially at a time of uncertainty about the U.S. economy. But exactly how do you spot quality?

To find out, I recently caught up with an investment manager whose mutual fund has "quality" in the title - Tom Hancock, of the GMO Quality Fund GQETX.

Of course, anyone can put the word "quality" in a fund name. But Hancock has a performance record that tells us he actually knows what he is talking about. He's beaten both competing funds and the Morningstar US Large-Mid Cap Index by up to 3 percentage points annualized over the past five and ten years, says Morningstar Direct. That sets him apart from most fund managers, who struggle to beat the market.

A Harvard-trained software engineer at IBM (IBM) before getting into money management, Hancock now uses his coding skills to create screens that X-ray the market for financial characteristics that identify quality. Hancock is different from most quantitative investors because he also actually drills into the business and sector trends behind the stocks he owns.

Note that the minimum investment level at Hancock's fund is high, so his firm also offers a lower-cost exchange-traded-fund version of the same strategy called GMO US Quality ETF QLTY.

Here are four tactics Hancock uses to identify a quality company:

1. Look for unique assets that competitors cannot duplicate: Rich profit margins over a long time is a major clue, telling you that competitors have had difficulty duplicating those assets. Hancock says an established pattern of rich profitability is a better predictor of stock performance than a track record of growth, which fails to forecast future growth.

Next, understand what the asset is. "A record of high profitability does not tell us what the quality asset is," says Hancock. "But we know there is one." Often, it is more of a concept; for example, a strong relationship with customers can be the quality asset.

Consider Microsoft (MSFT). You won't find Apple (AAPL) fans who believe that Microsoft offers the best software. But Microsoft doesn't win by making the best software; it wins by selling products that become deeply embedded in companies.

"Once you are embedded, it is hard to dislodge you," Hancock notes. "And that is a really great, long-term advantage. If you have a suite of Microsoft products, it is so much easier to add an incremental feature from Microsoft; the switching costs to use another vendor are high."

Strong customer relationships just as easily arise from simply doing a good job. Here, Hancock cites the reliability of Taiwan Semiconductor Manufacturing (TSM) in its chip production. Apple has a similar strength: "People love their iPhones," says Hancock. His fund also owns TJX (TJX), whose customers enjoy the "treasure hunt" aspect to shopping in its stores.

A patented product can also be the source of consistently high margins. Here, Hancock cites fund holding Eli Lilly (LLY) and its patents on GLP-1 weight loss drugs Mounjaro and Zepbound. Hancock expects insurance reimbursements to expand beyond use to treat diabetes, given all the health benefits of losing weight.

2. Look for companies that can keep investing in projects with high returns: This helps keep the high profit margins alive. Here, Hancock cites portfolio holding Meta Platforms (META). It is one of the few companies so far to successfully invest in AI in a way that pays off, because it helps place ads in front of the right users.

Another example is portfolio holding Intuitive Surgical (ISRG) which has a dominant position in robots that help surgeons. The company is expanding into robots can assist with more procedures.

3. Look for companies with capital discipline: Hancock likes to see companies that keep their balance sheets healthy by avoiding frivolous investments. This gives them the flexibility to return cash to shareholders via buybacks or dividends.

A portfolio holding that checks all these boxes is analog chip maker Texas Instruments (TXN). The company invests to build out its own manufacturing capacity, which helps make it a low-cost supplier. Hancock adds that Microsoft also does a good job of investing to develop new products while paying a dividend and maintaining a solid balance sheet.

4. Look for relatively cheap companies: Rather than using standard valuation metrics like price-to-earnings or price-to-sales ratios, Hancock and his team build discounted cash-flow models. These estimate the net present value of companies based on projected earnings.

Despite their stock strength since this bull market started in October 2022, Microsoft, Meta and Alphabet (GOOGL) (GOOG) all still have attractive valuations, according to Hancock's discounted cash-flow models. Because they have unique assets and opportunities to invest for good returns, they can generate strong enough growth to justify what look like lofty valuations using standard metrics like P/E ratios. Says Hancock: "The outlook several years from now will be every bit as rosy, so we do not expect valuations to come down."

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned MSFT, AAPL, AMZN, and TSM. Brush has suggested MSFT, AAPL, AMZN, TSM, LLY, KO and TXN in his stock newsletter, Brush Up on Stocks. Follow him on X @mbrushstocks.

More: Attractive Nvidia and Alphabet prices could be a stock-market October surprise. Here's why.

Plus: 'Sell in May' was a costly mistake. Should you buy stocks now at record highs?

-Michael Brush

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09-30-24 0720ET

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