Why Eliminating Poor-Quality Companies Improves Your Portfolio Returns

• Published : September 03, 2026

Quality investing is built on an idea most of us already understand from everyday life: one rotten apple in a basket doesn't just sit there quietly, it speeds up the decay of every apple around it. Take it out early, and the rest of the basket stays fresh for much longer. Leave it in, and you eventually lose apples you never needed to lose.

Equity portfolios work the same way. A handful of fundamentally weak companies, with poor governance, unsustainable and higher debt, or volatile and unstable earnings, can quietly drag down the returns of an otherwise well-built portfolio, and often do the most damage exactly when markets turn volatile. 

This is the core idea behind quality factor investing: a rule-based investment strategy that systematically screens out fundamentally weak companies, which are the rotten apples, before a single rupee is deployed. 

In this blog, we break down the real, data-backed benefits of eliminating poor-quality companies from a portfolio, and explain why NJ Mutual Fund has built its entire investment philosophy around a quality-first approach.

What Does Poor Quality Mean in Investing?

In the context of factor investing, a poor-quality company typically shows one or more of the following red flags:

• Negative or deteriorating Return on Equity (ROE): It is a sign the business isn't generating profit efficiently for shareholders
• High debt-to-equity ratios: Excessive leverage that increases financial fragility
• High promoter share pledging: It is often an early warning sign of governance or liquidity stress
• Excessive price volatility: Unstable earnings or speculative trading patterns
• Weak forensic accounting scores: Indicators of aggressive or misleading financial reporting

Individually, any one of these traits can hurt returns. Combined, they compound into portfolios that are far riskier than the broader market, without offering any extra reward for that risk. Just like a rotten apple, these companies rarely stay contained; their weakness shows up as sudden, sharp drawdowns that pull down overall portfolio performance, which is why it is important to eliminate poor quality companies from the portfolio.

The Data: What Happens When You Don't Screen for Quality?

Numbers make this easier to understand than the theory alone,

The data shows that for the period March 31, 2009 to April 30, 2026, portfolios built entirely from weak-quality stocks were compared against the Nifty 500 TRI:

Source: NSE, CMIE, NJ Asset Management Private Limited Internal Research, NJ’s Smart Beta Platform (in-house proprietary model of NJ AMC). Data for the period March 31, 2009 to April 30, 2026. The above portfolios represent stocks exhibiting weak characteristics on the respective parameters under consideration. This data represents a back-tested simulation and does not represent the performance of any existing mutual fund scheme managed by NJ Asset Management Private Limited. Past performance may or may not be sustained in future and is not an indication of future return.

The pattern is unmistakable: every poor-quality portfolio delivered lower returns, lower risk-adjusted returns (Sharpe ratio), higher volatility, and nearly double the maximum drawdown of the broader market. In other words, investors in fundamentally weak companies took on significantly more risk for meaningfully less reward.

This single data set captures the essence of why eliminating poor-quality companies isn't just a defensive tactic, it's a proven driver of better risk-adjusted outcomes.

Key Benefits of Eliminating Poor-Quality Companies

1. Lower Portfolio Volatility

Weak-quality stocks which are those with high leverage, negative earnings quality, or governance concerns often tend to swing far more violently than the broader market. As the data above shows, volatility in low-quality portfolios ranged from 22.76% to 28.16%, compared to just 17.08% for the Nifty 500 TRI. Filtering these companies out at the portfolio construction stage smooths the overall investment journey.

2. Shallower Drawdowns During Market Corrections

Perhaps the most important benefit of a quality screen shows up during downturns. Fundamentally weak companies with high debt or pledged shares are typically the first to collapse in a falling market, which is why some poor-quality portfolios above saw drawdowns exceeding -80%, more than double that of the Nifty 500 TRI. Eliminating these names in advance protects capital precisely when protection matters most.

3. Better Risk-Adjusted Returns

A high return means little if it comes with extreme risk. The Sharpe ratio, a measure of return earned per unit of risk taken, was more than double for the Nifty 500 TRI (0.46) compared to most poor-quality portfolios (0.19–0.34). Quality screening isn't about chasing the highest possible return; it's about earning consistent, sustainable returns for the risk taken.

4. Reduced Governance and Fraud Risk

High promoter pledging and weak forensic accounting scores are early indicators of governance issues that can lead to sudden, sharp value destruction, often with little warning. A disciplined, rule-based elimination process removes these companies systematically, rather than relying on discretionary judgment that can be influenced by market sentiment or bias.

5. A Stronger Foundation for Long-Term Compounding

Quality businesses which are those with strong ROE, healthy balance sheets, and consistent earnings, are more likely to compound wealth steadily over 5–7 year cycles, which is the minimum horizon most factor-based strategies need to realise their full potential. Removing weak companies at the start increases the probability that the remaining portfolio can deliver on this long-term compounding promise.

Why NJ Mutual Fund Follows a Quality-First Approach

At NJ Mutual Fund, quality isn't treated as just one factor among many, it is positioned as the non-negotiable foundation of every portfolio. This philosophy is built into the our broader identity as being Built on Rules, where disciplined, 100% rule-based investing replaces subjective, emotion-driven decision-making.

Here's how this plays out in practice:

• Elimination-first portfolio construction: Before any factor-specific strategy (Quality, Value, or Momentum) is applied, every stock is first screened against a common baseline: weak forensic score, high volatility, and low quality are grounds for automatic exclusion from the eligible universe of Nifty 500 stocks.
• Consistency over discretion: Just as sorting out the rotten apples first means any recipe made from the rest turns out reliably good, our pre-defined, rule-based quality filters aim to deliver consistent investment outcomes independent of which fund manager is at the helm.
• Why Quality Matters: Quality forms an important foundation in the investment process. By focusing on businesses with stronger fundamentals and excluding companies that fail to meet defined quality parameters, the approach aims to create a more robust investment universe before applying any specific investment strategy.

The Bigger Picture: Why This Matters for Investors

Markets are cyclical, and no single factor–be it Quality, Value or Momentum–outperforms in every calendar year. But across cycles, staying investing compounds wealth.

For long-term investors, especially those investing through SIPs over 5–7 years or more, this reduced downside risk can be the difference between staying invested through a correction and panic-selling at the worst possible time.

This is precisely the discipline a 100% rule-based, quality-first investment philosophy is designed to enforce by removing emotion and subjectivity from the process, and replacing it with a transparent, pre-tested and, repeatable framework.

Conclusion

Go back to the basket of apples: you don't need every apple to be perfect to enjoy a good basket, you just need to keep the rotten ones out before they spread. Eliminating poor-quality companies from a portfolio works the same way. It isn't about being overly conservative, it's about avoiding avoidable risk. By building quality elimination into selection of the companies for portfolio construction, we aim to give investors a smoother, more resilient path to long-term wealth creation. Because THE PRICE OF IGNORING QUALITY IS LOWER RETURNS AND HIGHER VOLATILITY.

FAQs:

Q) What does quality mean in investing?
It refers to high and consistent ROE, low debt, high and consistent dividend payout along with the other traits that separate fundamentally sound companies from weak ones.

Q) Does eliminating poor-quality companies reduce returns?
No. Data shows weak-quality portfolios actually delivered lower returns and much steeper drawdowns than the broader market. And so, eliminating them improves consistency.

Q) Can a poor-quality company still give high short-term returns?
Yes, weak companies can occasionally rally sharply in the short term, especially in speculative market phases. But over the long run, data shows such companies tend to underperform with far higher risk.

Investors should consult their financial advisers if in doubt about whether the product is suitable for them.

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