This post first appeared on Alpha Architect Blog: https://alphaarchitect.com/2019/10/22/the-quality-factor-what-exactly-is-it/
While the quality factor has been identified in the literature (including papers such as “Buffett’s Alpha,” “Global Return Premiums on Earnings Quality, Value, and Size,” and “The Excess Returns of ‘Quality’ Stocks: A Behavioral Anomaly”), and there are now a number of investment vehicles with quality strategies (such as the iShares Edge MSCI USA Quality Factor ETF, or QUAL, and Invesco S&P 500® Quality ETF, or SPHQ), there is no consistent definition of the factor as there is with other factors. Note that while value is generally defined in the literature by the price-to-book (P/B) metric, there are also other accepted measures, such as price-to-earnings (P/E), price-to-cash flow (P/CF), and price-to-earnings before interest, taxes, depreciation, and amortization (P/EBITDA), etc.
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). Companies with these attributes historically have provided higher returns, especially in down markets. In particular, high-quality stocks that are profitable, stable, growing and have a high payout ratio outperform low-quality stocks with the opposite characteristics. If you happen to be really excited about profitability I’ve previously covered using it as a factor in an early post. Using their own definition, AQR found that, for the period from 1958 through 2018, the quality premium had an annual average return of 4.7 percent, a standard deviation of 9.6 percent, and a Sharpe ratio of 0.5.
Jason Hsu, Vitali Kalesnik and Engin Kose contribute to the literature on the quality factor with their study “What Is Quality?” which was published in the Second Quarter 2019 issue of the Journal of Financial Analysts. They noted that MSCI, FTSE Russell, S&P, Research Affiliates, EDHEC, and Deutsche Bank, among others, have created quality indexes for licensing and have typically included quality as part of their multifactor offerings.
Because of the lack of consistency when implementing quality, Hsu, Kalesnik, and Kose examined which traits were responsible for the quality premium. They examined the following traits: profitability, earnings stability, capital structure, growth, accounting quality, payout/dilution, and investment, noting that each of the six index providers listed above uses substantially different characteristics in their portfolio construction. They tested each of the traits for robustness (using three to eight definitions, such as return on assets and return on equity for profitability) and pervasiveness (time and geography) as well as whether it had been explored thoroughly in peer-reviewed journals. Specifically, they examined factor performance in five regions: the United States, Global Developed, Japan, Europe, and Asia Pacific excluding Japan. The U.S. data covers the period 1963 through 2016, while global data covers the period 1990 through 2016.
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