While “Quality” has a considerable dispersion in definitions,1 it is known as a factor focusing on profitability and safety in the context of factor investing. While the profitability component includes indicators such as return-on-equity (ROE) and return-on-assets (ROA), the components related to safety capture the defensive characteristics of companies in terms of capital structure, earnings stability, and earnings quality (see Figure 1).
Figure 1 : Examples of Factor Components and Indicators of Quality
From such characteristics, Quality is classified as a defensive factor, exhibiting lower risk characteristics than cyclical factors such as Value, Size, and Momentum. Higher returns from factors such as Value, Size, and Momentum are generally considered to be compensation for additional risk, whereas defensive factors like Quality and Low Volatility are regarded as persistent anomalies based on behavior and cognitive bias of investors. This paper first introduces the academic history of Quality and its practice in equity investing. It then discusses the benefit of incorporating Quality into other factors and strategies, focusing on factor diversification, risk mitigation, and return enhancement.
1. History and Practice of Quality Investing
Quality is a relatively new factor in the academic history of factor investing. The origin of factor investing can be traced back to Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) in the 1960s and 1970s, which defined the structure of the factor model. Research on individual factors such as Value, Size, and Momentum followed from the 1970s to the 1990s. Although Sloan (1996) was one of the earliest studies on Quality, which validated the excess returns of high-earnings quality stocks, lively discussions took place mainly in the 2010s led by Novy-Marx (2013), Asness et al. (2013), and Fama and French (2013).
While being classified into a relatively new group of factors, Quality has very old roots in the practice of equity investing. Benjamin Graham, known as the father of value investing, wrote that investors should look for quality companies (with sustainable earnings power), as well as valuation metrics such as earnings-to-price (Graham, 1949). Warren Buffett, a notable disciple of Graham, is also considered to have focused on Quality. Frazzini et al. (2018) reported that portfolio returns of Berkshire Hathaway can be explained by adding Low Volatility and Quality to conventional factors such as Value, Size, and Momentum.
2. Benefits of Quality
There are several key benefits of incorporating Quality into other factors and strategies. In this section we first focus on the diversification benefit from the perspective of correlation with other factors. Second, we discuss the risk mitigation effect in terms of quantitative measures and business cycles. Finally, we cover the return-enhancement aspect by using a divided discount model and comparing return characteristics of Quality and Low Volatility.
Factor diversification is expected when incorporating Quality into common investment styles such as Value, Growth, and Low Volatility. Figure 2 shows correlations of factor returns based on factor and style indexes of MSCI. The correlation between Quality and Value is -0.52, as they have opposite properties in terms of factor definition and economic characteristics. Due to their low correlation and different levels of effectiveness in the business cycle, a diversification effect can be gained by combining the opposite two factors.
The correlation between Quality and Low Volatility is relatively low at 0.35, even though they are the same defensive factors. This is because Low Volatility is a low-risk factor based on stock price return information, whereas Quality captures the low-risk characteristics of a company from a fundamentals perspective. By combining these two different low-risk factors, we can provide a multifaceted defensive investment solution that utilises both stock price returns and fundamentals information.
Growth and Quality tend to have a positive correlation (0.46), as Quality has components related to Growth such as profitability. On the back of the affinity between Growth and Quality, the combination of the two will contribute to improve and stabilise investment performance.
Figure 2 : Factor Return Correlations
Due to the defensive nature of Quality, risk mitigation and hedging effects on the downside of the business cycle are expected by incorporating Quality. Figure 3 shows the three risk measures (volatility, beta, and maximum drawdown) for factor and style indexes of MSCI World. The lowrisk characteristics of Quality can also be confirmed from these quantitative risk measures.
Quality is a defensive factor from the perspective of the business cycle. Figure 4 shows the performance of Quality with trailing-36-month rolling returns and the Composite Leading Indicator (CLI) of OECD, which suggests global economic trends. The figure shows that Quality tends to be effective in recessions, due to its safety-related components.
Figure 3 : Risk Measures of Factor and Style Indexes (MSCI World)
Figure 4 : Effectiveness of Quality in Business Cycle (Flight to Quality)
Here we discuss the return improvement effect of incorporating Quality by using a classic dividend discount model. Assuming a payout ratio of 1 to simplify the discussion, Gordon’s growth model can be rewritten to express a stock’s expected (required) return as follows2:
In Value investing, a higher return is expected due to low valuation (price-to-book). But bargain stocks may be bargains for a good reason, such as low growth and/or profitability (so-called value traps). To avoid or mitigate the risk of such value traps, the above formula suggests the importance of also considering Quality (profitability). Quality is also relevant for Growth investing, as higher valuation may result in lower returns than expected although the stock may have higher growth potential.
The terms related to low risk do not explicitly appear in the above formula, but low-risk equities are generally considered to have stable earnings with low growth potential. Given the difficulty of discussing the valuation of low-risk equities consistently, Quality is also relevant to improving the expected return in low-risk investing.
Resiliency in Upturns
Figure 5 plots factor returns of Low Volatility and Quality against MSCI World. Low Volatility shows a clear downward slope, indicating strong downside protection but weakness on the upside. And while similar defensiveness can be also seen for Quality, the fitted curve bends upward in the extreme, which suggests resistance in the upside.3 This mild concavity is considered to be derived from the profitability component of Quality. By combining Quality with such return characteristics and Low Volatility, we can provide an enhanced low-risk solution that improves the followability in the upside market without impairing the downside protection of Low Volatility.
Figure 5 : Factor Return Plot Against Market Return
Quality investing, focusing on profitability and safety, has been practiced by investors for a long time, though the strategies employed were not always identified as Quality. In our current investing landscape, there are numerous benefits of incorporating Quality into other factors and strategies. In addition to risk-mitigation benefits, factor diversification and return enhancement can be expected from incorporating Quality into Value, Growth, and Low Volatility.
Asness, C., Frazzini, A., and Pedersen, L. Quality Minus Junk. Working paper, New York University, AQR Capital Management, 2013.
Cooper, M. J., Gulen, H., and Schill, M. J. (2008). Asset Growth and the Cross-Section of Stock Returns. Journal of Finance, 63(4), pp.1609–1651.
Fama, E. F. and French, K. R. A Five-Factor Asset Pricing Model. Fama-Miller Working Paper, University of Chicago, Dartmouth College and NBER, November 2013.
Frazzini, A., Kabiller, D., and Pedersen L. H. (2018). Buffett’s Alpha. Financial Analysts Journal, 74 (4), pp.35–55.
George, T. J. and Hwang, C. Y. (2010). A Resolution of the Distress Risk and Leverage Puzzles in the Cross Section of Stock Returns. Journal of Financial Economics, 96(1), pp.56–79.
Graham, B. The Intelligent Investor. NY : Harper Collins, 1949. Haugen, R. A. and Baker, N. L. (1996). Commonality in the Determinants of Expected Stock Returns. Journal of Financial Economics, 41(3), pp.401–439.
Novy-Marx, R. (2013). The Other Side of Value: The Gross Profitability Premium. Journal of Financial Economics, 108(1), pp.1–28.
Sloan, R. (1996). Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings? Accounting Review, 71(3), pp.289–315.
1. Examples of variables as quality indicators include (derivations of) return-on-equity (Haugen and Baker, 1996), low accruals (Sloan, 1996), low investments (Cooper et al., 2008), low leverage (George and Hwang, 2010), and gross profitability (Novy-Marx, 2013).
2. We rewrite the Gordon model
Price = Dividend simply as Price = Profit ⁄ Book × Dividend ⁄ Profit Expected Return–Growth Book Expected Return–Growth
Here we develop discussions by replacing ROE with profitability and price-to-book with valuation, and treating profitability as a proxy for Quality.
3. Such return concavity is also reported for a quality-minus-junk factor by Asness et al. (2013)
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“A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market.”
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