The Quality Factor — What Exactly Is It?

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The existence of a quality premium in stocks that has been persistent over time, pervasive around the globe, and robust to various definitions have been well documented by studies, such as “Buffett’s Alpha,” “Global Return Premiums on Earnings Quality, Value, and Size,” and “The Excess Returns of ‘Quality’ Stocks: A Behavioral Anomaly.”

While there is no consistent definition of the quality factor (as there is with other factors), quality stocks typically have the following characteristics: low earnings volatility, high margins (profitability), high asset turnover (efficient use of capital), low financial leverage (little debt), low operating leverage (low fixed costs), and low specific stock risk.

These are the traits AQR Capital Management used to define their version of the quality factor: QMJ, or quality minus junk. Companies with these attributes historically have provided higher returns, especially in down markets.

Chi Cheong Allen Nga and Jianfu Shen contribute to the literature, providing out-of-sample results, with their study “Quality Investing in Asian Stock Markets,” published in the September 2020 issue of Accounting & Finance. They examined two quality investing strategies using gross profitability (GP, revenues minus costs of goods sold, scaled by total assets) or FSCORE (a measure of financial strength), respectively, over the period 2000–2016 in Hong Kong, Japan, Korea, Singapore, and Taiwan stock markets. 

They noted that previous studies documented that the FSCORE can successfully screen winners from losers in value stocks, and that the ratio of GP has strong predictive power on stock returns. Following is a summary of their findings:

  • Both FSCORE and GP are significantly positively associated with subsequent stock returns in cross-sectional regressions.
  • The FSCORE anomaly returns ranged from 0.16% per month in Japan to 0.38% per month in Taiwan. The ranged for GP anomaly returns was from 0.15% (Korea) to 0.86%(Singapore).
  • The returns on quality are not driven by small firms.
  • Actively managed financial institutions buy significantly more high-quality stocks than low-quality stocks in each of five Asian markets. The trading pattern is not significant in passively managed institutions.
  • Quality investing, instead of simple value investing based on only the book to market ratio, is more popular in the institutional investment decisions—institutional investors tend to follow the academic literature on anomalies.
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Anne Davis 1 month ago Member's comment

Who doesn't like a quality stock!