Start with the basics: What ‘quality’ really means in stocks & why it’s important

You simply have to ask a few consistent questions about any stock you’re considering. (AI image)

The word “quality” gets thrown around a lot in investing. Everyone claims to buy “quality stocks”, and every other fund calls itself a “quality fund”. But when you dig a little deeper and ask, “What exactly do you mean by quality?”, the answers often become vague. People point to well-known brand names, or to high share prices, or to whatever did well in the last bull market.For us, a quality company is not one that simply sounds impressive. It is one that consistently turns its business advantages into real cash, earns good returns on the money it invests, and treats minority shareholders fairly. That’s not a slogan; it’s a set of very specific behaviours.Start with the basics. A quality business is one that can grow its sales and profits steadily over long periods without relying on constant doses of fresh debt or equity. If you look at its track record over, say, the last 10-15 years, you should see revenues and earnings climbing at a healthy pace, not lurching from boom to bust. There will be bad years and good years, of course, but the direction over time should be unmistakably upwards.Take a company like Berger Paints. Between 2015 and 2025, its revenues have grown from around Rs 4,000 crore to nearly Rs 12,000 crore, while profits rose from roughly Rs 250 crore to almost Rs 1,200 crore. Across that period, its return on capital employed stayed broadly in the 25-30 per cent range. Meanwhile, its debt remained low or even declined as a share of the balance sheet. That’s what quality looks like in numbers: the business keeps growing, and each rupee invested continues to earn attractive returns.Then there is cash flow. It’s surprisingly easy for a company to show accounting profits while actual cash is stuck in receivables, inventory or dubious “other assets”. A quality company tends to convert a large part of its profits into cash from operations over time. If you see a pattern where the reported profit over, say, five years totals Rs 3,000 crore, but cumulative operating cash flow is only say Rs 1,500 crore, you have to ask why. In the best businesses, those two numbers are not worlds apart.The balance sheet tells its own story. Quality companies don’t habitually stretch themselves with dangerous levels of leverage. That doesn’t mean all debt is bad; in some industries, a reasonable amount is normal. But if borrowings surge every few years just to keep the lights on, or if interest costs eat up a growing share of profits, that’s a sign of weakness, not quality.And then there is behaviour, which often matters even more than numbers. How do promoters treat minority shareholders? Do they regularly pledge their shares to borrow money? Do they keep issuing new shares and diluting existing investors? Do they engage in related-party transactions that seem to benefit their private interests more than the company’s? Are auditors stable and independent, or do you see resignations, qualifications and frequent changes?Many of the worst blow-ups in Indian markets looked fine on a simple price chart until very late in the story. The early warning signs were usually in governance and capital allocation. At Value Research Stock Advisor, we place a lot of weight on these softer factors. Sometimes, we pass on a company even if the financials look attractive, simply because we don’t like what we see in the way management conducts itself. We’ve learned that it’s better to be roughly right about a slightly less exciting company than disastrously wrong about a glamorous name with poor governance.It’s also important to remember that a strong brand or a dominant market share does not automatically equal quality if it comes with sloppy capital allocation. A company that earns a high return on capital but keeps reinvesting in low-return projects will actually dilute its quality over time. In contrast, a management team that is disciplined about where it invests, and is willing to return excess cash to shareholders when it can’t deploy it sensibly, enhances quality.None of this requires you to become a forensic accountant. You don’t have to build complex models. You simply have to ask a few consistent questions about any stock you’re considering: does this business make good money, does it turn that money into cash, does it reinvest wisely, and does it treat me, the minority shareholder, with respect? If the answer to all of these is “yes”, you’re probably looking at a quality company.In our work at VRSA, we try to pass the listed universe through exactly this kind of lens before anything even reaches the stage of a formal recommendation. That’s why you’ll often see a bias in our ideas towards companies with clean balance sheets, decent history and reasonable governance track records, even if they are not the hottest names of the moment. We would rather miss a spectacular but fragile story than compromise on quality.Over long periods, quality tends to show up in the share price as well, despite all the noise along the way. In the example of Berger Paints, an investor who held from around Rs 124 in 2015 to approximately Rs 500 in 2025 would have earned roughly 15 per cent annualised, even though there were plenty of ups and downs in between. That return didn’t come from magic. It came from a business that kept doing the boring, difficult things right.When you hear the word “quality” next time, don’t think of it as a label someone slaps on a stock. Think of it as a habit pattern in a company’s life: steady growth, strong returns on capital, real cash generation, sensible leverage, and honest, competent stewardship. If you tilt your portfolio towards such companies and avoid the ones that only look impressive, you give yourself a much better chance of sleeping well while your wealth grows slowly in the background.(Ashish Menon is a Chartered Accountant and a senior equity analyst in Value Research’s Stock Advisor service.)(Disclaimer: Recommendations and views on the stock market, other asset classes or personal finance management tips given by experts are their own. These opinions do not represent the views of The Times of India)