By Jack Forehand, CFA, CFP® (@practicalquant) —
We all want to own great companies. We look at Warren Buffett’s success and want to own the same types of businesses he did. We love high returns on capital. We love great brands. We love strong balance sheets. We love MOATs and consistent earnings. The logical progression from that idea is that building a portfolio of high-quality companies should lead to great investment returns over time.
But like most things in investing that seem obvious, it isn’t always that simple. There are many nuances to using quality in an investment portfolio that are important to understand.
Here are some things to keep in mind when using quality in an investment strategy.
Quality Is In the Eye of the Beholder
The value factor is fairly easy to define. There are obviously many different metrics you can use to define value, but they all are a function of comparing the price of a stock to some sort of fundamental. So even though each value metric is unique, they at least rhyme in terms of what they are looking for.
Quality is very different, though. At a high level, quality is about investing in companies with good, profitable, consistent businesses. But how you identify those types of companies varies widely among investors.
Here is a description of the many factors that can go into defining quality from AQR Capital Management.
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)
This definition shows just how many different ways an investor can view quality. It can be looked at as investing in firms with high margins or high returns on capital. It can also involve investing in firms with consistent sales and earnings over time. It can also be defined using balance sheet related criteria like low debt or high asset turnover.
Joseph Piotroski also developed an interesting quality metric with his F Score. The F Score seeks to separate value stocks that are cheap for a reason from those that are fundamentally sound. It looks at return on assets, change in return on assets, cash flow from operations, cash compared to net income, change in long-term debt to assets, change in current ratio, change in shares outstanding, change in gross margin and change in asset turnover.
But the bottom line is that when you look at any implementation of quality, it is important to dig into the details because one firm’s definition is likely very different from another’s.
Even though there are many ways to measure quality, there is some common ground and we’ve captured some of these quality measures in Validea’s Factor Report. We key in on six different financial metrics as a way to evaluate quality across companies. Those figures are:
- ROE (Return on Equity): A financial ratio that measures the amount of net income returned as a percentage of shareholders’ equity. It indicates how well a company is using its equity to generate profits.
- ROTC (Return on Total Capital): A financial ratio that measures the amount of net income returned as a percentage of total capital (both debt and equity) invested in a business. It indicates how effectively a company is using its capital to generate profits.
- Gross Margin: A financial metric that calculates the difference between a company’s revenue and cost of goods sold (COGS) as a percentage of revenue. It indicates the profitability of a company before taking into account its operating expenses.
- Net Margin: A financial metric that calculates the difference between a company’s revenue and all of its expenses (including operating expenses, interest, and taxes) as a percentage of revenue. It indicates the profitability of a company after taking into account all of its expenses.
- Sales Consistency: A measure of how consistent a company’s sales are over time. It takes into account factors such as seasonality and cyclical fluctuations in the business.
- EPS Consistency: A measure of how consistent a company’s earnings per share (EPS) are over time. It indicates the predictability of a company’s earnings and the stability of its financial performance.
Why Does Quality Work?
On the surface, it is easy to think that buying high quality businesses should produce an excess return. And the academic research shows that quality does, in fact, do exactly that. But the reason it does that may be different than what you think. If you believe that the market is efficient, then most stocks should be fairly priced relative to the information that is publicly available. Great businesses typically trade at premiums to bad ones. In an efficient market, buying high quality companies wouldn’t produce an excess return because you would have to pay more to acquire them.
Investing factors that work over time typically do so for one of two reasons: either they are riskier than the market and investors get paid for taking on that risk, or they capitalize on some sort of systematic mispricing due to investor behavior.
Applying that framework to quality is difficult, though. It is hard to argue that buying high quality companies is riskier, and most practitioners don’t believe there is a risk-based argument for quality. It is also hard to argue that investors would systematically underprice high quality companies. But most researchers do believe that the mispricing argument is what best explains why quality works. Some argue that investors tend to focus too much on the short-term and thus overprice companies doing well over short periods of time relative to high quality companies that deliver more consistent long-term results. Others argue that investors overstate their own skill and try to find diamonds in the rough, which leads them to overprice those types of securities relative to high quality firms.
But either way, the success of quality is more difficult to explain than other factors like value and momentum.
Value With a Side of Quality
It is also important to keep in mind that quality and value can’t be completely separated from each other. The reason is that certain value metrics have quality embedded in them, while others don’t. Price/Book loads negatively on quality, but other metrics that get at the earnings power of a company like the PE Ratio, EV/EBITDA or Price/Cash Flow load positively on it. By using those metrics, you are getting higher quality companies without directly using quality metrics. This is another reason that a value composite works well for investors who use the Price/Book. Adding the other metrics helps solve the negative quality problem is has embedded in it.
The Enigma of Quality
In the end, quality remains somewhat of an enigma. It can be difficult to define, and every firm that uses it seems to have their own unique take on what works best. And it clearly works over time, but the reason it does so is tough to pin down, which makes some question whether it will work going forward. In the end, its best use may be as a supplement to the other major investing factors, where it can help to boost risk-adjusted returns. Quality may not have the evidence to support it that value and momentum do, but when used properly, it can be an enhancement to many portfolio strategies.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.