A Detailed Look at the Quality Factor

By Jack Forehand, CFA

There is probably no investing factor that makes more sense to your average investor than quality. We all want to own great companies – think Apple, Microsoft, Google, JP Morgan. We love to invest in companies that consistently compound their earnings over time. And owning high quality, brand name businesses certainly makes you sound smarter at cocktail parties than owning cheap value stocks that many people think will never bounce back. It seems intuitive that building a portfolio of high-quality companies should lead to great investment returns over time.

But like most things in investing that seem obvious, it isn’t always that simple. There are many nuances to using quality in an investment portfolio that are important to understand. We discussed many of these on our most recent episode of Excess Returns and I wanted to outline them in more detail here.

Here are some things to keep in mind when using quality in an investment strategy.

Quality Means Different Things to Different People

The value factor is fairly easy to define. There are obviously many different metrics you can use to define value, but they all are a function of comparing the price of stock to some sort of fundamental. So even though each value metric is unique, they at least rhyme in terms of what they are looking for.

Quality is very different, though. At a high level, quality is about investing in companies with good, profitable, consistent businesses. But how you identify those types of companies varies widely among investors.

Here is a description of the many factors that can go into defining quality from quant firm AQR Capital Management.

AQR Capital Management has defined the factor (QMJ, or quality minus junk) to be companies with the following traits: low earnings volatility, high margins, high asset turnover (indicating efficient use of assets), low financial leverage, low operating leverage (indicating a strong balance sheet and low macroeconomic risk) and low stock-specific risk (volatility that is unexplained by macroeconomic activity)

This definition shows just how many different ways an investor can view quality. It can be looked at as investing in firms with high margins or high returns on capital. It can also involve investing in firms with consistent sales and earnings over time. It can also be defined using balance sheet related criteria like low debt or high asset turnover.

When you look at any implementation of quality, it is important to dig into the details because one firm’s definition is likely very different from another’s.

Explaining Why Quality Works Can Be Difficult

On the surface, it is easy to think that buying high quality businesses should produce an excess return. And the academic research shows that quality does, in fact, do exactly that. But the reason it does that may be different than what you think. If you believe that the market is efficient, then most stocks should be fairly priced relative to the information that is publicly available. Great businesses typically trade at premiums to bad ones. In an efficient market, buying high quality companies wouldn’t produce an excess return because you would have to pay more to acquire them.

Investing factors that work over time typically do so for one of two reasons: either they are riskier than the market and investors get paid for taking on that risk, or they capitalize on some sort of systematic mispricing due to investor behavior. Value is a fairly easy factor to explain using this framework. As we all have learned all too well in recent years, value stocks are typically riskier than the market. Investors also tend to overestimate bad news, which leads to a systematic mispricing of value stocks. When the news comes in better than expected, value stocks benefit from multiple expansion.

Applying that same framework to quality is more difficult, though. It is hard to argue that buying high quality companies is riskier, and most practitioners don’t believe there is a risk-based argument for quality. It is also hard to argue that investors would systematically underprice high quality companies. But most researchers do believe that the mispricing argument is what best explains why quality works. Some argue that investors tend to focus too much on the short-term and thus overprice companies doing well over short periods of time relative to high quality companies that deliver more consistent long-term results. Others argue that investors overstate their own skill and try to find diamonds in the rough, which leads them to overprice those types of securities relative to high quality firms.

But either way, the success of quality is more difficult to explain than other factors like value and momentum. This has led some to believe that quality may not work as well out of sample as it has historically. As Wes Gray discussed in our recent podcast interview with him, factors that work over the long-term are typically associated with some sort of pain that investors that follow them have to endure. Although quality has clearly worked historically, it doesn’t meet that definition, which leads some to conclude that it won’t work as well going forward.

Quality Can Be a Great Complement to Other Factors

Rather than using it as a standalone factor, the best use of quality may be in conjunction with other factors. For example, combining quality with value can help to eliminate stocks from a value screen with significant problems in their underlying businesses. Some firms prefer to use quality as a negative screen where they eliminate the lowest quality companies, while others prefer to look for positive quality attributes, but either way, quality can be a significant enhancement to a value strategy. Also, as Wes Gray pointed out in our podcast interview, certain value metrics like Price/Earnings or Price/Cash Flow have quality embedded in them, so they can add quality to a value portfolio even if quality isn’t used directly.  

Quality can also offer an enhancement to momentum. We have found that adding fundamental momentum to a price momentum strategy can add an element of quality to it and improve risk-adjusted returns over time.

Quality can also help with investor behavior. It can reduce the risk of a factor like value, making it easier to stick with. And as I mentioned earlier, it can also lead to investing in the types of companies that investors feel good about owning, which makes it easier to stick with them when the inevitable down periods come.

The Challenge of Pinning Down Quality

In the end, quality remains somewhat of an enigma. It can be difficult to define, and every firm that uses it seems to have their own unique take on what works best. And it clearly works over time, but the reason it does so is tough to pin down, which makes some question whether it will work going forward. In the end, its best use may be as a supplement to the other major investing factors, where it can help to boost risk-adjusted returns. Quality may not have the evidence to support it that value and momentum do, but when used properly, it can be an enhancement to many portfolio strategies.

Photo: Copyright: 123rf.com / gajus

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.