10 shares for investors seeking high quality in 2019

Given uncertainties across global financial markets currently, Stockopedia's Ben Hobson explains how to find the highest quality stocks, and names the top 10 here.

After the ferocious final three months of 2018, the UK stockmarket has bounced in the early days of the new year. But many private investors will still be worried about how uncertainties like Brexit might influence conditions in the months ahead. 

Throughout all the volatility last year, the stocks that performed better in the market tended to be larger, slightly more defensive names. Those that suffered most were smaller stocks that had previously been fast growth, strong momentum plays. That's why we saw a more pronounced 18%-plus correction on the more speculative AIM All-Share compared to a less severe 13% dip in the hardier FTSE All-Share.

For investors thinking about how to position themselves for the year ahead, it could be worth considering the appeal of owning some of the market’s traditionally better-quality stocks. Typically, the best quality names come with expensive price tags. The inevitable trade-off for owning strong, resilient and dependable shares is that their popularity pushes up their prices.

Yet when the UK index started to slide sharply last autumn, even the highest quality stocks weren't immune. Of course, in these kinds of conditions, buying when everyone is selling is a desperately difficult thing to do. But look at the price action of some of those names in recent weeks, and it's clear that they are rebounding at a faster pace than the index. 

So what does quality look like? It's a topic we like to cover in this column because the most profitable, efficient and financially safe stocks are surprisingly easy to find with some basic financial ratios. So here's a quality checklist...

How to hunt for quality

One of the most popular measures of profitability is to look at how much bang a company gets from the pounds it invests in itself. This is called return on capital employed - or ROCE. A high return on capital, particularly over a long period, can be a pointer to stocks with strong and defensible brands and franchises that can be rolled out very profitably.

A second signpost to strong profitability is the percentage that a company keeps from selling its products after all costs have been deducted, or operating margin. High margins are often a hallmark of companies that can command high prices from their customers and have strong competitive advantages.

Competitive advantage is also something that can be explored by looking at what's known as return on equity. This is the technical term for comparing a company's net income to all the cash that investors have put into it. It's a popular way of comparing the profitability of companies in the same sector. ROE varies from industry-to-industry, but 15% is generally thought to be desirable.

Another check in the hunt for profitability is a ratio called free cash flow to sales. This useful comparison measures the proportion of sales revenues that actually turn into cash after everything else has been paid. Companies are sometimes criticised for producing impressive-looking accounts yet fail to generate hard cash. This cash flow ratio should help to spot them.

With these profitability measures in mind, this week's Stockopedia screen puts them to work to get an idea of some of the highest quality FTSE 350 stocks. The results are sorted by ROCE because it’s a useful initial starting point in the search for profitability and efficiency. The table also includes the one-month relative price strength of these shares so show how they've performed relative to the FTSE All-Share in recent weeks.

Source: Stockopedia Past performance is not a guide to future performance

Stocks like Rightmove (LSE:RMV), Games Workshop (LSE:GAW), Moneysupermarket.com (LSE:MONY), Euromoney (ERM) and Burberry (LSE:BRBY) have been scoring highly against this kind of quality checklist for years. Businesses like these often have the traits of 'economic moats' that insulate them from competition so they can produce strong, compounding returns over long periods.

Good quality, profitable companies can be some of the most dependable investments in the stock market. While they aren't immune to volatility, they can recover quickly. 

In the investor toolkit there are various ways of measuring that profitability - and they can be used on any occasion to separate those firms that are flattering their figures from those that are genuinely profitable.

It's worth remembering that high quality stocks can end up with expensive valuations that put them out of reach of investors with an eye for value. But from time to time, even the most popular names go on sale.

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