Value+Quality or High Quality Value Stocks?

Factor Portfolio Construction: Double-Sorting vs Combination

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

SUMMARY

  • Investors can either combine single-factors into a portfolio or sort stocks for several factor characteristics
  • Double-sorting seems to work better for Value & Quality than for Value & Momentum
  • The combination portfolios show the highest risk-return profiles, albeit at lower returns

INTRODUCTION

London recently hosted the World Championships in Athletics where sportsmen competed in a variety of disciplines. Most were specialists, like Usain Bolt in sprinting, but there were also decathletes who aim to be good across 10 different types of track and field events. In factor portfolio construction investors have the choice of selecting specialists and combining these in a portfolio or picking multi-disciplinarian stocks. In this short research note we will consider the difference between selecting single factors and combining them versus double-sorting stocks on different factors.

METHODOLOGY

We’re going to focus on Value in the US and Europe and are going to combine and double-sort once with Quality and once with Momentum. Combining factors will simply be a portfolio of the two single factors with equal allocations and yearly rebalancing. Double-sorting implies sorting stocks on Value and either Quality or Momentum and then look for the stocks in the intersection, i.e. that rank highly for Value and Quality or Momentum. In a combination portfolio we will therefore have twice the amount of stocks compared to a double-sorted portfolio.

The factors are constructed as long-short portfolios by taking the top and bottom 10% of the stock universes in the US and Europe. Value is based on price-to-book ratios, Quality on return-on-equity, and Momentum on the 12 month return excluding the last month. Only companies with a minimum market capitalization of $1bn are considered and 10bps of transaction costs are included.

VALUE & QUALITY US: DOUBLE-SORTING VS COMBINATION

Value investors like Warren Buffett frequently take Quality metrics into account in stock selection, mainly in order to identify hidden gems, i.e. stocks that are cheap but have good balance sheets, decent operating margins, or some other indicators of corporate stability or profitability. Alter