Ten quality large-cap UK shares

If you don’t meet the $2mn (£1.5mn) minimum account threshold for UBS’s wealth management services, you can at least console yourself with the knowledge that its advice isn’t very original.

“We believe quality stocks – companies with strong competitive positions, exposure to structural trends, healthy balance sheets, and resilient earnings streams – are well-placed to deliver performance,” the bank’s strategists revealed in a ‘house view’ note to clients last week. “We recommend focusing on quality growth stocks in the tech sector and beyond.”

It’s hard to know where to start. Is a competitive position defined by market share, or the ability to take it from others? Which company doesn’t have “exposure to structural trends”? What, for that matter, does “deliver performance” mean? And what of this focus on “the tech sector and beyond”? After all, the combined weighting to tech, healthcare, communication, and industrials stocks in MSCI’s global quality index isn’t much more than the regular all-country benchmark.

‘Quality’, though hard to escape, is a particularly annoying piece of investing-speak. For one, owning quality companies features high on the list of priorities of most equity investors. The challenge lies in identifying quality in advance, working out when a once-resilient earnings stream is drying up, and understanding competitive dynamics in industries whose high returns invite new capital all the time.

In addition to its subjective and tautological nature, ‘quality’ is also a double-edged sword. Because the word tends to refer to relative strength, it often involves a valuation premium. But 2022 proved this isn’t always a strong defence.

That all said, I shouldn’t be so snippy. Wealth managers such as UBS are judged on their ability to preserve and grow wealth, not on the originality of their views. The new path might be more interesting, but if it’s unchartered, it’s also less certain.

Above all, ‘quality’ also works as a stock picking strategy. As an investing strategy, it might feel ineffable, but the corporate features that are normally associated with quality – high margins and returns on equity, manageable debts, free cash flow and solid projected growth – all point to something bigger than the sum of its parts.

Still, it’s worth dissecting attempts to quantify the subject. MSCI’s own quality indices, for example, are a two-step process. First, MSCI applies a quality rating to each stock, based on a standard score of its returns on equity, debt to equity levels and earnings variability. Second, this score is multiplied by each stock’s market capitalisation, thereby tilting in favour of those with higher ratings.

By repeating this process twice a year, MSCI’s global quality index has outperformed the broader market over the past three decades. This is in part thanks to quality stocks’ strong relative returns during recessions, which is what you’d expect of companies with stronger balance sheets and less volatile (read cyclical) profits. Higher returns on equity provide the kicker in better times.

Our High-Quality Large Cap screen, which focuses only on UK companies with a market capitalisation of £1bn or more, has done a better job of finding alpha than MSCI’s all-world quality tilt, even if it has fallen short of the latter’s absolute performance.

Since we started running the screen in 2011, it has returned 569 per cent on a total return basis, compared to 174 per cent from the FTSE All-Share and 626 per cent from the sterling-denominated MSCI All-Country Quality index. On an annualised basis, that equates to a very handy 15.7 per cent, versus 7.9 per cent from the UK benchmark.

While our stock screens are intended as a prompt for further research rather than an off-the-shelf portfolio, if we introduce a notional 1.25 per cent annual charge to account for the real-life costs of trading then the screen’s overall return would decline to a still very strong 468 per cent.

The past 12 months has been better than average. Despite identifying just five companies that met its criteria in 2023, the screen managed a 17.6 per cent total return, versus 15 per cent from the All-Share, thanks to another excellent trading performance from controls and seals specialist, Diploma (DPLM).

Given the lack of diversification, it’s hard to draw too many conclusions from this performance. But over a slightly longer period, a couple of important features stand out.

The first is that quality factors do appear to offer a bulwark against broader pessimism. Over the past five years, the screen’s all-time total return has climbed by 72 per cent, even as the CBI’s business confidence index has been twice as negative as its average over the 13-year life of the screen. Quality companies often find a way to defy the gloom, by expanding into markets where growth is strong.        

Second is that this resilience is eventually recognised. After initially lagging the benchmark by 13.2 percentage points, the screen’s 2021 selections – while yet to fully recover – have since outperformed the broader market, suggesting that the criteria that make up the high-quality screen can work over holding periods greater than a year. That’s not something we can say about all of the stock screens that appear in these pages.    

This year, 10 stocks passed all tests, including 2023 selections Diploma and Hill & Smith (HILS) and the standout detractor in 2021’s weak showing, Games Workshop (GAW). Details on each can be found in the table below, and in more detail in the downloadable spreadsheet, here: