Quality Ratings
Quality Ratings use a scale of A, B, C, D, and F, and are assigned to a growing list of publicly traded, dividend-paying stocks from all over the world. Our philosophy is that over a long-term average, A-rated stocks will deliver better risk-adjusted returns than B-rated stocks, and so forth.
All ratings should only be used to complement your own due diligence when making investment decisions.
Quality Ratings Introduction
Quality Ratings are based on a methodical approach that evaluates each stock based on three broad categories: Moat, Profitability, and Safety.
This approach attempts to measure a company’s overall quality, since over the long term it has been empirically demonstrated that higher quality companies produce better economic returns, and over the long term stock prices tend to follow the returns of the underlying company.
Stocks of high and potentially improving quality tend to receive the best Quality Ratings (”A” or “B” ratings), while stocks of low and potentially worsening quality tend to receive the worst Quality Ratings (”D” or “F” ratings).
Over time, RatedA may update the Quality Ratings methodology. For more information on the components of the Quality Ratings, see Quality Ratings Components.
Quality Ratings Performance
We continuously measure the success of our Quality Ratings in ranking stocks according to the quality of their underlying companies. We expect that the differences in quality among A-rated, B-rated, C-rated, D-rated, and F-rated stocks will be reflected in the long-term returns of each rating category.
The performance of each Quality Rating is measured over a one-year period and compared to the MSCI World Index over the same timeframe. This tracking period is refreshed annually with each rating update.
Quality Ratings Explanation
13 – 15 Component Score: If an investor is looking to add a stock to his or her portfolio, A-rated stocks may be the best candidates for consideration.
10 – 12 Component Score: An investor looking to add a stock to his or her portfolio should also consider B-rated stocks, although preference should be given to A-rated stocks.
7 – 9 Component Score: An investor holding a C-rated stock should consider whether it is appropriate to continue to hold that stock in his or her portfolio. An investor would not usually consider a C-rated stock for purchase.
4 – 6 Component Score: An investor holding a D-rated stock should consider whether it is appropriate to eliminate that stock in his or her portfolio. An investor would not usually consider a D-rated stock for purchase.
0 – 3 Component Score: An investor holding a F-rated stock should strongly consider whether it is appropriate to eliminate that stock from his or her portfolio. An investor would not usually consider a F-rated stock for purchase.
Quality Ratings Components
Moat: A moat is a sustainable competitive advantage that allows a business to protect its profits and market share from competitors. In a capitalist world, excess profits get competed away as new entrants invest in industries promising high returns on investment.
In other words, a moat is a defence mechanism against competition. And its presence is required for a business to sustain high rates of return over extended periods of time.
Moats can take four forms: network effects, switching costs, intangible assets (such as brands, patents, and geography), and economies of scale. Every stock will get a Moat Component Score from one to five. Stocks with high scores in this category are likely to have more durable cash flows than those with low scores.
Profitability: Over time, the price of a stock will follow the free cash flow generation of the underlying company. Companies that generate a consistent, growing stream of cash flow tend to become more valuable over time, thereby providing value for shareholders.
Companies with attributes such as pricing power, scalability, mission criticality, recurring revenue, and low capital expenditure requirements typically generate better returns on capital and have an easier time growing cash flows.
Every stock will get a Profitability Component Score from one to five. Stocks with high scores in this category are likely to grow their cash flows faster than those with low scores.
Safety: The value of a stock is determined by the total cash flows the underlying company will produce over its existence. Companies with predictable profits are less likely to face the risk of permanent capital loss.
Companies exposed to large debt obligations, government regulation, litigation, patent expiry, and overall negative secular trends have higher variability in future expected outcomes, and their cash flows are therefore less predictable.
Every stock will get a Safety Component Score from one to five. Stocks with high scores in this category have more predictable cash flows than those with low scores.
Why Use Quality Ratings
The long-term outperformance of quality companies relative to the broader market is well documented in financial literature. And many of the most successful investors have used a strategy focused on quality to generate exceptional returns.
Charlie Munger’s influence over Warren Buffett led him to pivot away from ‘cigar-butt investing’ and towards higher quality businesses. Nick Sleep crushed the market by investing exclusively in three companies that he considered superior to all others. Both Chuck Akre and Terry Smith achieved excellent returns by implementing simple strategies centred on a company’s quality.
Quality companies are compounding machines, and investors with long time-horizons will be well served by simply owning these businesses for as long as possible. This strategy requires patience and is mostly passive. The aim is to minimise trading activity, thereby reducing fees, taxes, and the risk of errors, which allows the power of compounding to take effect.
Special Considerations
Here are some special considerations when using our Quality Ratings.
Consider the following:
- The quality of the ratings depends on the accuracy of financial data provided by third parties, including the companies in our coverage.
- This approach was created for a buy-and-hold, long term investing strategy. Quality Ratings may not be appropriate over shorter investment time frames.
- Quality Ratings do not consider stock valuations, which can significantly influence returns over shorter investment time frames. We recommend using our 10-Year Shareholder Return Calculator to minimise valuation risk before buying any stock.
- Quality Ratings are typically updated annually, shortly after companies publish their annual reports. Quality Ratings are focused on long-term outcomes. While the overall quality of a company does not change materially from quarter to quarter, our ratings may not reflect the possible impact of recent news and business developments. Investors should always do their own research before making a trading decision.
- Quality Ratings and all related publications are not personal recommendations for any particular investor or client. All opinions provided are based on sources believed to be accurate and are written in good faith, but no warranty, representation, or guarantee, whether expressed or implied, is made as to the accuracy of the information provided by our service.