Quality vs Growth Factors
Why do high ROE stocks outperform high-growth ones?
- Quality and growth factor returns differ between research and reality
- Most generated negative excess returns
- Profitability was profitable, which can be partially attributed to the tech bias
INTRODUCTION
Based on the body of research available, factor investing remains the only approach with a strong record of delivering long-term outperformance. We can also explain – reasonably and logically – why it should work. For instance, value investing involves buying companies that are widely disliked, often because of self-inflicted setbacks or industry headwinds. Investors, in essence, get paid for pain.
Similarly, investors are compensated for holding “boring” stocks that exhibit low volatility. Conversely, there’s little reason to expect a premium from high-growth stocks. Yet the Fama–French five-factor model includes profitability as a factor – one that has historically delivered a positive excess return (read The Odd Factors: Profitability & Investment). This raises a question: why should investors earn a premium for owning highly profitable companies that are neither boring nor cheap?
In this article, we examine the quality factor versus the growth factor to explore that puzzle.
QUALITY VS GROWTH FACTORS (LONG-SHORT)
We focus on the U.S. stock market, constructing several quality and growth factors by selecting the top and bottom 10% of stocks ranked by various metrics. Companies with market capitalizations below $1 billion are excluded and stocks are equal-weighted. Portfolios are rebalanced monthly, incorporate transaction costs of 10 basis points, and are constructed to be beta-neutral.
From 2004 to 2025, only two of our six long-short factors – return on equity and low volatility – produced positive excess returns, consistent with findings in both academic and industry research. Leverage, operating margin, and sales or earnings growth did not deliver a positive premium.
