Quality: How Do You Spot Good All-Rounders?

Factor investing has gained popularity in the last few years. Factors are attributes that are likely to influence investment returns; for example, the low volatility factor may outperform by focusing on assets with lower fluctuations than others, while the momentum factor may generate potentially higher but riskier returns.

It can be hard to find a consensus on the definition of quality. In general, “quality stocks” refer to companies that demonstrate consistently solid fundamental ratios over a long period of time. These may include stable earnings, robust balance sheets, strong cash flows and higher margins.

In 2014, Eugene Fama and Kenneth French of the famed Fama-French Three-Factor Model added two new quality factors to their factor model, namely:

• Profitability (companies with a high operating profitability perform better)
• Investment (companies that invest conservatively have better returns than those who invest more aggressively)

Some researchers have suggested that quality can also be applied to “softer”, harder-to-quantify criteria when analyzing stocks, such as leadership, corporate governance or the company’s market position.

Compared to the other investment factors, quality lacks a long record of empirical evidence. However, among the available academic studies it is evident that single or combinations of strong fundamental factors have enabled quality stocks to outperform other stocks. In their research titled “Quality Minus Junk” (2013), Clifford S. Asness, Andrea Frazzini and Lasse H. Pedersen of AQR Capital Management define the quality factor as “investing in the stocks of safe, profitable, expanding and well-managed companies”. You can’t argue with that. Perhaps more importantly, in times of market crashes or dislocations quality stocks tend to be better protected against market volatility.³

How Is Quality Measured?

Apart from the metrics mentioned above, other common quality metrics on equities include:

• High return on assets, potentially indicating efficient use of assets
• Low earning accruals, potentially indicating high quality earnings
• Low operating leverage, potentially indicating a strong balance sheet

There has been less research on the quality factor in the fixed income space. However, shorter duration bonds (which measures the sensitivity to changes in interest rates), credit ratings and leverage are some useful metrics.⁴

At The Index Standard, we think the quality factor is useful for the stability it can provide. In good times, quality will not deliver spectacular returns. But in times of market stress, quality can outshine other more aggressive factors and outpace benchmarks with better returns, with lower volatility and drawdowns.

Other Factors

Visit The Index Standard Guides for information on other popular investment factors.

References

1. Eugene F. Fama & Kenneth R. French, Common Risk Factors in the Returns on Stocks and Bonds, 33 J. FIN. ECON. 3 (1993).
2. A Five-Factor Asset Pricing Model, Eugene F. Fama, University of Chicago, Kenneth R. French, Dartmouth College. September 2014
3. The Quality Factor—What Exactly Is It? Larry Swedore, Alpha Architect 10/19/2019
4. Factor investing in the Corporate Bond Market, Robeco, Patrick Houweling and Jeroen van Zundert Financial Analysts Journal, Spring 2017