On January 4, 2022, BlackBerry shut down its smart phone servers for the final time, ending over two decades of service. Many would argue that the original BlackBerry device was responsible for kicking off the tidal wave of smart phone adoption. But not coincidentally, the BlackBerry service was ended almost 15 years to the day after Apple Inc. announced its first iPhone.
The rise and fall of BlackBerry—previously known as Research in Motion—is well-known to individuals who lived through the early-adoption stages of the smart phone revolution. This storied relic of corporate communication might also help illustrate an important characteristic of the quality factor that explains the source of its return premium.
Members of the smart beta investment community, both professional and academic, generally fall into one of two major camps that explain the existence of smart beta factor premiums: one can be described as risk-based, and the other, behavioral. The risk-based argument states that markets are efficient, so securities with higher exposures to factors can produce a higher return only if these securities represent some higher form of risk. In order for investors to justify holding these higher risk securities, capital markets must compensate them with the prospect of increased returns on average and over the long term.
The value and size factors tend to be more closely associated with the risk-based explanation. Companies that have operated inefficiently, that have become distressed and that now face riskier prospects tend to see their stock prices decline, pushing them into deeper value territory and greater size exposure as well. In other words, distressed companies tend to see both their valuations and their market capitalizations decline. Some of these companies will ultimately fail but some will successfully bounce back, and in doing so, reward their investors handsomely. The combination of the winners and losers ultimately produces an expected long-term excess return premium.
The behavioral argument states that the psychology of investors and the natural structures of markets produce factor premiums because investor behavior is consistently biased towards those securities which exhibit higher exposure to those factors. This behavioral bias pushes markets and boosts returns. The momentum and low volatility factors tend to be more associated with the behavioral explanation.
The quality factor is a bit of a conundrum as it can’t be easily sorted into either the risk-based or the behavioral camp. On one hand, it doesn’t seem to make intuitive sense for higher quality companies to be riskier, thereby requiring superior returns in the equity capital markets to attract investors. Companies with excellent quality characteristics—higher profitability being one of those characteristics1—would seem to be less risky for the investor, not more. And it’s tough to imagine what sort of behavioral bias would induce higher quality companies to generate increased returns.
In the early stages of the smart phone revolution, BlackBerry was not a high quality company. It was not until late 2006 that BlackBerry unit sales started to take off, jump-starting profits and moving BlackBerry from the lower end of the quality spectrum to the higher end. In turn, BlackBerry’s stock price increased five-fold over the next two years. From 2006 to 2008, the higher quality nature of BlackBerry was indeed accompanied by a higher return (Figure 1).
But as BlackBerry sales continued to grow, driving profits and pushing BlackBerry even higher along the quality spectrum, BlackBerry’s stock returns did not keep pace. BlackBerry’s stock price peaked in mid-2008 and fell precipitously from there, despite unit sales and net income continuing to grow into 2011, and despite the company being in the top quality quintile all the way into 2013.
What happened to BlackBerry is quite simple—competition. Apple entered the smart phone market with the iPhone in 2007, and Google launched its Android operating system in 2008. These two smart phones devoured BlackBerry’s market share, sending unit sales into decline from 2011 onward and ultimately closing down the BlackBerry for good by 2022.
Perhaps this explains how the quality factor fits into the risk-based explanation for its premium. High profitability is a prominent element of quality, and those companies with high profitability do not go unnoticed by market participants. A highly profitable company essentially has a target on its back, enticing new entrants to capture some of those juicy profits for themselves. We tend to think of “riskier companies” as those that are currently distressed. Perhaps “riskier companies” also includes those which face the risk of significantly increased competition.
Companies that completely fail are usually value companies or small cap companies just before they go out of business. The premium is generated by those companies that somehow pull out of their death spiral, rewarding their investors who take that risk. Similarly, highly profitable companies are those whose soaring profits are inevitably going to be attacked by new competition. Those that survive the competitive onslaught earn a return premium, rewarding investors who remained invested in the face of that expanding competition.
Unfortunately, for companies like BlackBerry, being a highly profitable, high quality company may involve some elevated and unexpected risks, as we have proposed here, in the form of new competition. Competition in profit-generating markets can be fierce, and highly profitable companies don’t always win their fight to stay that way.
1 In this context, quality refers to the SSGA definition of quality which is a combination of three characteristics: profitability (ROA), leverage (D/E) and earnings variability.
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