How I Made $5000 in the Stock Market

These ‘Quality’ Stocks Are Trading at a 40% Discount to the Market. Act Now.

Dec 26, 2025 01:00:00 -0500 by Jack Hough | #Companies #Cover

(Illustration by Valerie Chiang)

The rally in low-quality names is bound to end in 2026. The S&P 500 isn’t cheap, either.

Key Points

“We’re incautiously optimistic—buy hot garbage,” advised none of the big investment firms a year ago in their 2025 outlooks. Pity. The S&P 500 index, despite a springtime tariff wobble, has so far returned a splashy 18%. And since the beginning of March, speculative, low-quality stocks have beaten high-quality ones by 50 percentage points, UBS finds. It predicts 10% more upside for the U.S. market in 2026, but says that investors should now bet on high quality: “The sharp rally in low quality appears unsustainable amid elevated uncertainty and extreme crowding.”

Quality sounds intuitively appealing to any shopper, from car-lot tire kickers to produce-aisle melon sniffers. For investors, high-quality companies bring to mind financial resilience—just the thing today to offset concerns over runaway artificial-intelligence spending, or a recent rash of flaky business models, like companies that raise cash to hoard crypto. If UBS is right that quality stocks are statistically due for a bounce, all the better.

There are only two problems. First, there is no widespread agreement on how to define quality stocks, so funds with “quality” in the name can vary widely in their approach. Second, the most popular of these funds currently hold pricey shares. For example, the iShares MSCI USA Quality Factor exchange-traded fund, ticker QUAL, trades at 26 times estimated 2025 earnings.

Investors who use a better approach can find quality stocks trading at discounts of 40% or more to the market. Some ETFs and seven stock picks in a moment.

The broad stock market isn’t cheap. The S&P 500 goes for 25 times earnings, versus just under 18 times earnings, on average, over the past two decades. So, it’s understandable if the iShares quality ETF, QUAL, goes for a little more, but it’s a bigger turnoff that it does so after having underperformed since its launch in 2013. Also, its top holdings include many of the same giants that dominate the S&P 500, like Apple, Microsoft, Nvidia, and Meta Platforms. If the purpose of buying a quality fund is to diversify against a core S&P 500 position, that might not be ideal.

To find a better approach, let’s first dig into some of the metrics that funds use to separate high-quality stocks from the rest. The most common of these is called return on equity. That’s a year’s worth of a company’s earnings divided by the net accounting value of the things it owns. In simplest terms, ROE answers the question: How much money does this company make relative to its stuff? In not-quite-as-simple terms, well…

At Virginia Tech University, there is a building formerly called Graduate Life Center at Donaldson Brown, or informally, DB. It’s named for an electrical engineering alum who landed a job in 1909 selling explosives for the E.I. du Pont de Nemours Powder Company, and eventually worked his way up to treasurer. One of Brown’s financial innovations, today called DuPont analysis, involves breaking ROE down into its constituent factors to tell why it is high or low. Try jotting down three fractions separated by multiplication signs: earnings/sales x sales/assets x assets/equity. Recall from grade school fraction math that you may cancel diagonally; the two “sales” disappear, as do the “assets.” What’s left is earnings over equity, or ROE. If it’s too low, try to improve your profit margins (earnings/sales), or bring in more business using less stuff (sales/assets). Or, somewhat less ideally, maybe throw on some leverage (assets/equity).

You can see where this last factor, leverage, might unduly flatter the ROE of overborrowers. Some indexes that select for high ROEs will separately look for low leverage. QUAL does both of these things, plus it favors high earnings stability.

There are many variations in other quality funds. Invesco S&P 500 Quality ETF, or SPHQ, tracks stocks chosen for ROE, leverage, and something called the accruals ratio. It measures how much of a company’s earnings come from noncash accounting adjustments. The accrual ratio is sometimes called the Sloan ratio, after an accounting professor named Richard Sloan, whose research showed that companies with cleaner earnings generally produce superior stock returns. (He is no relation to famed General Motors head Alfred P. Sloan, who, as it happens, brought in DuPont’s explosives-man-turned-treasurer to help blow up inefficiencies.)

Fidelity Quality Factor ETF, or FQAL, weights three measures equally. One is return on invested capital, or ROIC, a cousin of ROE that’s harsher on heavy borrowers. The others are free-cash-flow margin and free-cash-flow stability—more on free cash flow in just a moment. Virtus Terranova U.S. Quality Momentum ETF, or JOET, favors shares that are running higher. JPMorgan U.S. Quality Factor ETF, JQUA, says only that it looks for “profitability, quality of earnings, and solvency.” And so on.

This is a strange business. An investor seeking Japanese stocks, or utilities, or high dividend yields, can find ETFs filled with exactly those things. But one who orders up quality stocks might be served a choice of two ETFs as far apart as mashed potatoes and marshmallows. Which method is best?

Jared Woodard, head of the Research Investment Committee at Bank of America, has studied the factors used to screen for quality stocks and finds that ones based on free cash flow produce the best results. Casual investors tend to focus on earnings and are often less familiar with free cash flow, which is ironic. Of the two measures, free cash flow is by far the simpler. Picture a mom-and-pop store with an old cigar box for a till. Customer money goes in. Store costs come out. What’s left at the end of the day or week is free cash flow.

Earnings, on the other hand, are designed to tell a tidy story. If a company spends $50 billion this year to build and fill hyperscale AI data centers, it doesn’t subtract that money from earnings right away. It calls it a capital investment, and deducts it from earnings little by little. Just how many years it should stretch out those deductions can be, and is now in the case of AI computing power, the subject of some debate. Think of free cash flow as earnings stripped of storytelling and excuses. When free cash flow is divided by the enterprise value of a company—the cost to buy all of a company’s shares and pay off its debt while using its available cash—the resulting free cash yield can be a powerful signal of quality.

“Historically, investing in a basket of stocks that score well on this measure…has performed about 15%, 16% total returns a year since the early ’90s,” says BofA’s Woodard. “That’s about five percentage points a year better than the S&P 500, which has already by itself been a pretty good place to invest.”

This is perhaps a touch controversial. Free cash yield is just a smarter relative of the price/earnings ratio. Wouldn’t that make a fund that uses it a value fund rather than a quality fund? Perhaps, although free cash yield also demonstrates a company’s ability to be tactical in good times and bad, making it a quality hallmark, too. It hasn’t been immune to the decadelong trouncing of value stocks by growth stocks.

One fund that leans heavily on free cash yield, the Pacer U.S. Cash Cows 100 ETF, just turned 10 years old and has lagged behind the market since inception. It’s at least appropriately cheap, at 15 times earnings. And its underlying index has an impressive record when viewed over 30 years. Woodard gives top marks to a newer fund, the VictoryShares Free Cash Flow ETF, ticker VFLO, which launched two years ago and is running a few points ahead of the S&P 500. It screens first for free cash yield, and second for sales and earnings growth. The portfolio goes for 14 times earnings, and expenses are 0.39% a year.

Investors can also screen for their own quality stocks using a mix of approaches. We did so recently using free cash yield, while keeping an eye out for healthy ROEs and recent analyst upgrades.

Unsurprisingly, some of the names turn up in both the QUAL and VFLO quality ETFs, like Merck. It has the world’s best-selling drug, called Keytruda, which helps the immune system attack cancer cells, and launched more than a decade ago. That means the company faces key patent expirations starting in 2028. But Wells Fargo Securities upgraded the stock to Overweight in November based on a bright growth outlook into the 2030s. Merck has directed its considerable free cash flow toward recent acquisitions to offset future Keytruda declines, and its development pipeline will yield a string of key trial readouts over the next 18 months.

Last Christmas, Brent crude went for $73 a barrel. Now, it’s about $10 cheaper. Yet Chevron stock has managed to produce a small gain this year. UBS calls the company the best-in-class upstream player, or producer, following a legal battle with Exxon Mobil and takeover of Hess that brought vast reserves in Guyana. At a $70 average Brent price, UBS estimates that free cash flow could grow by 10% annually over the next five years.

Expedia Group scores well on free cash generation and growth, and poorly on popularity, with barely a third of analysts who cover the stock recommending a purchase. The company is small relative to Priceline owner Booking Holdings, especially in hotels, which are much more lucrative than flights and rental cars. But Expedia, under new management since last year, solidly beat quarterly bookings estimates in early November, sending its stock 18% higher in a day.

Deckers Outdoor is best known as the maker of Ugg boots, even though sales there are likely to be overtaken in the coming year by the company’s Hoka brand of pillowy running shoes. The stock has slipped on a banana peel this year, losing half of its value. Growth rates for Hoka have slowed from 50%-plus a few years ago, to 20%-plus over the past two years, and now, to low-teens percentages. In mid-November, investment bank Stifel upgraded the stock to Buy from Hold, citing management meetings that boosted confidence in Decker’s long-term ability to increase Hoka sales at low-double digit percentages, and Ugg at low to mid-single digit ones.

Longtime dog AT&T turned things around by getting out of show business and satellite dishes, and focusing its free cash on paying down debt, shoring up its dividend, and rolling out more fiber broadband to compete with cable. The stock has beaten the market over the past two years. A selloff since September on competitive concerns in wireless offers bargain hunters another look. KeyBanc Capital Markets upgraded the stock to Overweight from Sector Weight in November, calling wireless challenges overblown, and AT&T a leader in convergence, or the bundling of fiber broadband and wireless service, which tends to help with both profit margins and customer turnover. The dividend yield is 4.6%.

General Motors stock is doing something highly uncharacteristic: beating the stock market. Investors have made 135% over the past two years. Electric-vehicle demand has skidded, and tax perks have been scrapped. By keeping its EV bets modest, GM has avoided taking a massive loss like its rival Ford Motor recently did. Morgan Stanley upgraded GM stock to Overweight from Equal Weight in December, citing increased focus on lucrative fuel-burning vehicles. Shares go for eight times projected 2025 earnings, and earnings are expected to grow by 15% a year over the next two years.

Omnicom Group stock has underperformed the U.S. market by 50 points over the past two years on concerns over advertising demand and the rising industry presence of Amazon.com and other digital giants. In November, Omnicom bought Interpublic Group, creating the world’s largest holding company of ad agencies. Expect layoffs, reduced real estate, and other cost-cutting. By 2027, UBS predicts $1 billion in yearly savings, higher profit margins, and $2 billion in stock buybacks, leading to earnings per share of $11.35, up from just over $8 last year. Shares traded recently at seven times the higher figure—a tempting pitch from an industry known for them.

Write to Jack Hough at jack.hough@barrons.com. Follow him on X and subscribe to his Barron’s Streetwise podcast.