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The lowdown on 'high quality' stocks

By Penelope Wang

(Money Magazine) -- The advice is so common that it's almost a cliché: If you want to play it safe in this scary market, stick with "high quality" stocks.

S&P analyst Richard Tortoriello, for one, says, "High-quality stocks are likely to perform better over time, as well as offer more downside protection" than the speculative shares that thrive early on in a recovery.

But don't all the stocks you own exhibit good qualities that made you buy them in the first place? When the pros say "high quality," what they're really referring to are firms with the proven ability to deliver strong and steady results over the long term. Here are three attributes that such winners sport:

A high return on equity

While profits are the ultimate way to measure performance, raw earnings don't tell you whether a company is maximizing its resources.

That's where a different gauge, return on equity (ROE), comes into play. ROE measures how much profit a firm earned relative to what shareholders have invested in the business.

Procter & Gamble (PG, Fortune 500), for example, generated net income of about $13 billion over the past 12 months. When you divide that by what shareholders invested in P&G -- around $63 billion -- you get an ROE of 20%.

Companies with ROEs of 15% or higher are considered highly efficient (you can search for them using the stock screener tool at morningstar.com).

At the quality-conscious Jensen Fund (JENSX), the managers look for firms that have delivered 15% or better ROEs each year for the past 10 years.

"If a company produces a high ROE over different market cycles, it's a sign that it also has a healthy balance sheet and effective management," says Jensen co-manager Eric Shoenstein. Among Jensen's top holdings: Abbott Labs (ABT, Fortune 500), with a 27% ROE, and Emerson Electric (EMR, Fortune 500), with a 20% ROE.

Steady dividends -- or the ability to pay them

Companies that routinely pay generous dividends of, say, 2.5% or higher -- like 3M (MMM, Fortune 500) or Johnson & Johnson (JNJ, Fortune 500) -- generate healthy amounts of cash. That's a sign of strength. But firms don't have to throw off income to be high quality, says Larry Puglia, manager of T. Rowe Price Blue Chip Growth (TRBCX).

Google (GOOG, Fortune 500) and Apple (AAPL, Fortune 500), which rank among Blue Chip Growth's biggest stakes, don't pay dividends, but each produces $9 billion or more in cash flow annually. If Google took half that and used it for dividends, the stock would yield about 3%.

Solid growth prospects

If you want to know whether a firm can continue to deliver strong earnings, see if it enjoys competitive advantages to keep rivals at bay. Our stock columnist Pat Dorsey refers to this as having a "wide economic moat."

Not all industry leaders enjoy such advantages. Take Hewlett-Packard (HPQ, Fortune 500), which faces stiff competition not only from its direct PC peers, but from networking and data-storage companies as well, according to Morningstar. On the other hand, McDonald's (MCD, Fortune 500), vying with fast-food chains on virtually every corner, actually has a big advantage -- the security of its real estate holdings.

If you don't want to pick stocks, go with a fund that seeks solid growth potential, such as Jensen, Blue Chip Growth, and FMI Large Cap (FMIHX). All are Money 70 funds that stick with the bluest of the blue chips.  To top of page

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