Quality Factor in Sector Investing

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Author: Paula Tekulova

In general, a factor is described as a characteristic that can be associated with a group of assets, and it helps to explain their returns and risks. As noted in the literature focusing on CAPM, the market itself can be viewed as the primer and most significant equity factor. Besides the market factor, academics generally look for persistent factors over time with solid explanatory power over a wide variety of equities. However, many factors can’t be observed directly, and criteria on how to define them vary. Yet, everyone can agree on the three main categories in which we distinguish factors. To this day, the three main categories are: macroeconomic, statistical, and fundamental.

Macroeconomic factors include surprises in inflation, surprises in GNP, surprises in the yield curve, and other measures of the overall economy. Statistical factor models identify factors using statistical techniques. Fundamental, capture stock characteristics such as industry membership, country membership, valuation ratios, and much more.

As a part of risk factor modelling, the most prevalent factors represent value, size, momentum, and growth. One of the most common models is the Fama and French Three-factor model (1992). The model was developed as an expenditure of the CAPM by adding size risk factor (large vs small-capitalization stocks) and value risk factor (low vs high book to market) to the market risk factor used in CAPM. This model considers the fact that, on average, value and small-cap stocks outperform. The model accounts for this outperforming tendency by incorporating these two additional characteristics, which is considered a more robust tool for explaining the cross-section of stock returns. As the financial literature was evolving, other factors were recognized and utilized in asset pricing models. For example, momentum – a widely recognized factor was utilized in Carhart’s model (1997). Also, the original Fama French Three-factor model (1992) was augmented with another two factors – profitability and investments to better explain the variation in stock returns. However, not every widely popular investing style and corresponding factor/factors are utilized in the asset pricing models.

Foundations of Factor Investing

In recent years, the focus shifted to a broader range of factors. Consequently, not only value, momentum, and size are being recognized as the most popular, but also factors such as quality, volatility or other risk measures became the most studied and researched factors in the academic, financial world. In the table below, we can see their main characteristics and measurements.

FactorDefinitionMeasures
ValueCaptures excess returns from equities with low prices compared to their fundamental value.Book to price, earnings to price, book value, sales, earnings, cash earnings, net profit, dividends, cash flow
MomentumReflects excess returns to stocks with stronger past performance.Relative returns
SizeLarge vs small-capitalization stocks.The market capitalization of a stock
QualityCaptures excess returns to stocks that are characterized by low debt, stable earnings growth, and other “quality” metrics.ROE, ROA, earnings stability, growth, the strength of balance sheet, accruals, cash flows
VolatilityCaptures excess returns to stocks with lower than average volatility, beta, and/or idiosyncratic risk. Standard deviation, the standard deviation of idiosyncratic returns, beta
Dividend YieldCaptures excess returns to stocks that have higher-than-average dividend yields.Dividend yield

Quality – the most challenging factor to define

Quality has its roots in fundamental analysis (Graham, 2006), but recently, it has become popular as a systematic investment style. The Quality factor aims to capture the excess return of “high quality” companies vs junk companies. In theory, high quality (profitable, stable…) firms should perform reasonably well even during stressful periods in the market. This notion is supported by several papers such as Cook et al. (2017) or Lepetit et al. (2021). Hence the quality investing style is popular among practitioners.

On the other hand, from the theoretical point of view, the quality factor is perhaps the hardest to define as there is no consensus on the best way to measure it. Therefore it is one of the most discussed and controversial of all. Moreover, the quality of companies is a highly subjective matter. So how do we define a company’s quality? Quality companies need to have the financial strength to invest for the long term and have higher profitability with a record of stable business performance over a certain period. Furthermore, the best-performing companies have a good record of returning cash flows to their shareholders.

Although the quality definition can vary, the factor in stocks is well-examined in the literature.

The critical question of this research is to examine whether the factor could also be found in the aggregated groups of similar stocks such as industries or sectors. Similar questions puzzled academics in various anomalies and factors, for example, in momentum. While initially, the momentum was found in the individual stocks, researchers have also identified the momentum in industries or sectors.

The research examines the quality factor in the sectors. Additionally, instead of constructing a comprehensive quality metric like other papers, we examine the individual ratios aggregated to the whole sector. The aim is to investigate the fundamental ratios on which quality is based rather than the composite quality score of sectors. As a result, the research is mostly related to examining the individual building blocks of quality investing in sectors and leaves the construction of composite quality strategy (and non-fundamental quality metrics) for further research.

We define a quality stock through ratios based on the following three key characteristics:

Profitability – the main focus is on rates of returns such as return on equity (ROE) and return on assets (ROA), and for comparison, we also take ROE and ROA into account over the last five years. Next, we also analyze the net income ratio, gross profit, and for comparison, gross profit over the previous five years.

Financial strength –  Even though the debt is not always indicating a low-quality stock and some debt may be good, it is essential to distinguish between companies expanding via excessive financial leverage. Companies with modest leverage and ample ability to service that debt are more likely to be masters of their destiny. Consequently, quality companies have more opportunities to invest. Long-term debt to assets is a common quality factor that determines financial strength. We also examine the total money market investments ratio and payout ratio.

Stability – Profitability is a significant driver of relative stock returns over time that can be enhanced by focusing upon companies with more stable fundamentals. Analysis of the growth of different aspects is needed to determine the stability of a company. More specifically, we focus on the growth rate, assets growth, and net income growth. For example, it is expected that firms that invest too aggressively underperform firms with more conservative investments.

Definitions of ratios used in the quality stock analysis:

Gross profit is the most fundamental value that reflects what the company does, defined as the Total Revenue – Cost of Revenue. Particularly, what does the company receive for its goods, and what is the cost spent on its production. Companies with a high gross profit ratio have opportunities to make wise decisions on how they want to allocate their capital. Moreover, if a company has a low gross profit ratio, it indicates a low probability of success in the future. Gross profit is null if the cost of revenue is not given. However, the gross profit should be standardized because the standalone value might not be comparable. The Gross Profits to Assets ratio is a common profitability factor (Novy-Marx, 2013) used to assess how well a company utilizes its assets to produce profits. It is calculated as Gross Profits divided by the Total Assets of the company.

Gross profit over the last five years is the annual growth rate of the company’s gross profit over the previous five years.

Return on equity (ROE) is defined as net income divided by average total common equity.

ROE over the last five years is simply the average of the company’s ROE over the previous five years. Return on equity reveals how much profit a company has earned compared to the total amount of shareholders equity found on the balance sheet.

Return on assets (ROA) is calculated by dividing its annual earnings by its average total assets.

ROA over the last five years is again an average of the company’s ROA over the last five years.

Sustainable Growth rate represents the maximal growth rate of a company without additional equity or debt. In our case, the ratio is computed as ROE * (1 – Payout Ratio).

Assets growth is represented as the growth in the total assets on a percentage basis.

The payout ratio is a proportion of a company’s net income that gets distributed to shareholders through regular dividends.

Net income growth rate measures the percentage change – increase or decrease, in net income from one period to the next. It measures the company’s efficiency from an operational point and desirability from an investment point; however, it’s heavily influenced by a company’s goals and challenges.

Total money market investments are the sum of the money market investments held by a bank’s depositors, which are FDIC insured.

Net income is computed as a difference between sales and the cost of goods sold. More specifically, it tells how much revenue exceeds an organization’s expenses and indicates a company’s profitability.

The debt-to-equity ratio is determined by dividing a company’s total liabilities by its shareholder equity to assess its financial leverage.

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