Fundamental quality is a powerful return driver for stocks. However, the concept of quality can be difficult to define. Business quality clearly includes many soft variables such as the company’s competitive advantages and the capabilities of its management team, among many other variables that are hard to measure and quantify.

That notwithstanding, quality can also be analyzed in numerical ways, and business profitability is one of the most important indicators of underlying quality. There is a clear and direct relationship between business profitability and shareholder returns. If all other variables are the same, the more profitable the business, the higher its ability to create wealth for investors over time.

Besides, consistent profitability says a lot about a business. In a free market economy success attracts the competition, and competition erodes profitability levels over time. If a company is consistently making above-average profitability, this generally indicates that it has superior fundamental qualities such as differentiated competitive advantages or a visionary management team.

Quality Stocks by the Numbers

The following quantitative system is based on a ranking algorithm; this is materially different from a screener. A screening system will invest only in companies that meet a specific parameter – for example, the return on equity ratio is over 20% and the operating margin level is above 15%.

A ranking system, on the other hand, will rank companies in a particular universe based on return on equity and operating margin, and will invest in the companies with the higher ranking based on a weighted average of those indicators.

There are basically two ways to measure business profitability. Profitability on capital measures how much money the company makes on its assets, shareholder equity, or investments. On the other hand, profit margins on sales measure how much money the company makes as a percentage of revenue at different levels, considering ratios such as gross profit margin, operating margin, and free cash flow margin.

The ranking algorithm includes both kinds of profitability indicators. In particular, it covers return on investment (ROI), return on assets (ROA), return on equity (ROE), gross profit margin, operating margin, and free cash flow margin.

These factors are not only ranked in absolute terms, but also in comparison with the industry average for each company. Profitability varies substantially across different industries and sectors, companies in the software industry obviously make much higher margins on sales than those in discount retail, for example. This is because pricing power, the cost structure, and industry dynamics are completely dissimilar.

If the system is looking for top quality companies, it makes sense to overweight the sectors and industries that typically allow for superior profitability, so we need to consider profitability levels in absolute terms. In addition to that, if a company is producing profitability levels substantially above the industry average, this is arguably a strong reflection about the company’s underlying quality, even if profitability is not particularly high in comparison with the broad market.