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How to Earn Better Returns With Less Risk

What would you do if I handed you a map with the key to investing? This is the formula: high quality investments equal better returns and less risk and ultimately financial peace of mind.

Nobel Laureate economists say it’s impossible to beat the market with less risk. How exactly can you earn better investment returns with less risk? In a word: quality. Yes, it’s that simple. By focusing your investments in high quality businesses you can earn better returns with less risk. What is a high quality business? Companies that consistently grow their earnings regardless of the underlying business atmosphere are high quality.

Key Characteristics of Quality Companies

These companies tend to be the cream of the crop in their industry, with key competitive advantages that allow them to continually prosper over the long run. These businesses come in all shapes and sizes, although they typically exhibit three key characteristics:

  • Maintain outstanding financial strength.
  • Possess a unique business model.
  • Are run by top notch people.

As you can see, these are both quantitative and qualitative characteristics that high quality companies possess, making it difficult to judge quality. Just as beauty is in the eye of the beholder, quality is in the eye of the astute investor. (For more, see: 6 Rules for Successful Dividend Investing.)

Measuring Quality

Fortunately the financial service firm Standard & Poor’s (S&P) has published quality rankings over many years. This provides a simple method for measuring quality. These rankings are based on the company’s most recent 10 years of earnings and dividend data and range from A+ (highest) through D (Lowest). The better the growth and stability of earnings and dividends, the higher the ranking.

 “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” penned legendary investor Warren Buffett in his annual letter to Berkshire Hathaway shareholders in 1989.

High Quality Equals Better Returns

So why does one of the greatest investors of all time focus on buying wonderful companies at a fair price? The major reason is high quality stocks generate better returns over the long run. In a long term S&P study, over the 30 year time span between 1981-2011, High quality stocks (S&P Ranks B+ or better) earned average annual returns of 14.9% significantly outperforming its low quality counterparts (B or lower) at 8.7%.

It’s easy to forget that buying stocks is actually becoming an owner in a company (you get much more than a volatile ticker symbol). Over the long run your investment’s performance will ultimately be determined by the company’s business results. Since high quality businesses by definition are those with steady and superior earnings growth, it makes perfect sense that their stocks generate superior returns in the long run over their low quality counterparts.

To put the high quality versus low quality results from S&P’s study in dollar terms, if you invested $100,000 in low quality stocks in 1981 it would have grown to just over $1.2 million by 2011. That is nothing to sneeze at. However by comparison, a $100,000 investment in high quality stocks would have grown to $6.4 million - over five times the low quality amount. That is a remarkable $5.2 million difference over 30 years.

Given the superior performance of high quality investments that we just discussed, you might find it fascinating that they actually are less risky to boot. Who said you can’t have your investment cake and eat it too? (For related reading, see: Top 5 Positions in Warren Buffett's Portfolio.)