Quality Factor: How To Define It?

Same, Same, but Different?

July 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Different Quality definitions result in dramatically different return profiles
  • Questionable if there is structural alpha in the Quality factor
  • Investors would not have benefited significantly from exposure to Quality in the GFC

INTRODUCTION

The Greeks said that beauty is in the eye of the beholder, investors might say the same the Quality factor. It’s likely the factor where opinions are most diverse regarding the definition. Broadly speaking there are qualitative and quantitative evaluations and these are often combined in a scoring model. Criteria like management quality or the soundness of strategy are intuitively appealing, but difficult to verify given a lack of data. In this short research note we will analyse three quantitative criteria, which are commonly used when used in defining the Quality factor, and compare their return profiles (read Value & Quality Factor Valuations) .

METHODOLOGY

We will focus on three metrics: the debt-to-equity ratio, return-on-equity, and gross margins, which are chosen as they are available for all companies and therefore maximise the number of available stocks. We construct long and short portfolios in the US, Europe, and Japan based on the top and bottom 10% of the stock universes ranked by the quality metrics. The portfolios are created dollar-neutral and only feature companies with market capitalizations above $1bn.

THE QUALITY FACTORS ACROSS REGIONS

The chart below shows the performance of the three Quality metrics in the US from 2000 to 2017. The different Quality factors are mostly flat throughout the period, except for the early years. The debt-to-equity Quality factor lost approximately 50% of its value between 2000 and 2002, which can be explained by having debt-free Tech companies in the long portfolio during the Tech bubble implosion. The return-on-equity Quality factor shows the opposite as profitless Tech companies were in the short portfolio. We can observe that different metrics lead to quite different results.