Using ETFs to Identify Quality Stocks
Thursday, August 11, 2016

If one were to survey investors about what traits make a stock attractive, the top of the list would include an attractive valuation, a reasonable expectation of a price increase (particularly sooner rather than later), a sound underlying business model and good fundamentals. The first two traits are easy to identify: seek out below-average valuations and above-average momentum. The last two, referred to as “quality,” are harder to pin down.

Most people have a general idea of what quality is: profitable, low-to-manageable level of debt, adequate cash flow, etc. Quantifying the traits in a stock screen is difficult, however. Require too many traits and too few stocks will pass your screen. If you’re not restrictive enough, however, you may end up with junky companies or companies that are otherwise riskier than you desire. The line is easy to trip over when screening for stocks.

I’m trying to strike the right balance myself as I work to create my new stock strategy. I have the cornerstones narrowed down: low price to book with either low price to sales or low price to earnings. I’m also requiring an above-average level of momentum, as defined by relative strength rank. I'm trying to weed out the junky stocks without making the screen too restrictive where I’m running into challenges. One of the ways I’m seeking to resolve this problem is to look at what exchange-traded funds (ETFs) focused on quality are doing.

ETFs can be useful for creating a personal stock screening strategy because they mostly hold large portfolios (the median large-cap ETF holds 178 positions) and they mostly track indexes. The latter is key because with a little elbow grease, the index’s methodology—and thereby the criteria the ETF manager uses to select stocks—can be found.

I’ll walk you through what I did to show how this can be done. I searched our ETF Guide for large-cap ETFs whose names had the word “quality” in them. I then did a Google search on the indexes they tracked.

The iShares Edge MSCI USA Quality Factor ETF (QUAL) is the largest ETF to include “quality” in its name. This fund tracks the MSCI USA Sector Neutral Quality Index. A search on the index’s name quickly turns up its fact sheet. From this, we can see that the fund seeks stocks with high return on equity (ROE), low leverage and low earnings variability. A bit more searching through MSCI’s website turned up more detailed information. ROE is calculated using earnings per share for last 12 months divided by the latest book value per share. Leverage is total debt divided by book value for the latest fiscal year. Earnings variability is the standard deviation of earnings for the last five years. MSCI uses a ranked weighting (winsorizing) process to determine the construction of the index, which isn’t necessary for an individual investor who is simply looking for ideas to replicate.

The process can be replicated with other ETFs. The PowerShares S&P 500 Quality ETF (SPHQ) tracks the S&P 500 Quality index. This index considers ROE, accruals (change of a company’s net operating assets over the last year divided by its average net operating assets over the last two years) and leverage (latest total debt divided by book value). Like the MSCI index, the S&P 500 Quality Index uses winsorization to weight the variables.

The level of transparency or opaqueness varies by index. WisdomTree simply describes its U.S. Quality Dividend Growth Index, the basis of the WisdomTree U.S. Quality Dividend Growth (DGRW), as considering long-term earnings growth expectations for the growth component and the three-year historical average return on equity and return on assets for the quality components. Arrow Insights says that it looks at the consistency of historical earnings, return on equity, dividend yield and share repurchases without giving further detail for its AI Quality Momentum index. This index is tracked by Arrow QVM Equity Factor (QVM).

Others border on the realm of black boxes, including FlexShares Quality Dividend (QDF). This ETF tracks Northern Trust’s Quality Dividend Index. The index uses a “proprietary quality scoring model based on quantitative ranking of various metrics obtained from company filings.” A footnote lists the components as “management expertise (e.g., corporate finance activities), profitability (e.g., assess the reliability and the sustainability of financial performance) and cash flow.”

Even when it’s impossible to know the full methodology, there is often enough information to be able to determine what criteria the ETF is using to select stocks. This, in turn, can help those of you wanting to follow an active approach or further refine your stock selection strategy.

As I move along further with the process, I’ll share with you the criteria I'll be using to quantitatively analyze a stock’s quality traits. If you have a list of traits you use to screen for quality or exclude risky companies, let me know by either posting on the Discussion Boards or sending me a note.

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Highlights from the AAII Journal

The Week Ahead

Earnings season winds down, with just 20 members of the S&P 500 reporting. Included in this group are Dow Jones industrial average components Home Depot (HD) on Tuesday, Cisco Systems (CSCO) on Wednesday and Wal-Mart Stores (WMT) on Thursday. Several other retailers will also report, including Lowe’s (LOW) and Target (TGT) on Wednesday.

The week’s first economic reports of note will be the August Empire State manufacturing survey and the August housing market index, which will be released on Monday. Tuesday will feature the July Consumer Price Index (CPI), July housing starts and building permits and July industrial production and manufacturing capacity. The Federal Open Market Committee (FOMC) will release the minutes from its July meeting on Wednesday. Thursday will feature the Philadelphia Federal Reserve's business outlook survey for August.

Three Federal Reserve officials will make public appearances: Atlanta president Dennis Lockhart on Tuesday, St. Louis president James Bullard on Wednesday and San Francisco president John Williams on Thursday.

The Treasury Department will auction $14 billion of five-year Treasury inflation-indexed securities (TIPS) on Thursday.

What’s Trending on AAII
  1. The Individual Investor’s Guide to the Top Mutual Funds 2016

  2. Why Buy Bonds If Interest Rates Will Rise?

  3. Analyzing a Stock by Its Dividend and Shareholder Yield

AAII Sentiment Survey

Optimism among individual investors about the short-term direction of stock prices rebounded back above 30% in the latest AAII Sentiment Survey. Neutral sentiment pulled back modestly, while pessimism was unchanged.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 1.5 percentage points to 31.3%. The rise reversed last week’s decline. This is the 40th consecutive week and the 73rd out of the past 75 weeks with a bullish sentiment reading below its historical average of 38.5%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 1.5 percentage points to 42.0%. This is the 28th consecutive week with a neutral sentiment reading above its historical average of 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, is unchanged at 26.8%. Pessimism is below its historical average of 30.5% for the sixth consecutive week.

Bullish sentiment is above 30% for the fifth time in six weeks. This fact shows just how low optimism has been. Over the span of the past 12 months, bullish sentiment was at or above 30% during 14 out of 16 weeks between August 12 and November 25, 2015, and during six out of seven weeks between February 24 and April 6, 2016. The remainder of the time, optimism has mostly stayed below 30%. So, while still low, optimism has improved recently overall on a comparative basis.

This week’s special question asked AAII members how, if at all, they have adjusted their investing strategy recently. More than half of all respondents (55%) said they are focusing on or have shifted more into stocks, particularly value and dividend-paying stocks. Slightly more than 27% of respondents say they have not changed their strategy. Nearly 12% said they are increasing their cash allocation. About 8% said they are taking a more conservative approach. Some respondents listed more than one than one asset class or investing style.

Here is sampling of the responses:

  • “Recently changed focus to value and dividend-paying stocks.”
  • “Moving toward higher-yield value stocks, but with a healthy emphasis on small-cap growth.”
  • “Holding more cash than usual. Waiting for a buying opportunity.”
  • “Have not changed. See no reason to.”
  • “Moved more to cash. P/E ratios are about as high as I can stand.”

This week’s Sentiment Survey results:

Bullish: 31.3%, up 1.5 points
Neutral: 42%, down 1.5 points
Bearish: 26.8%, no change

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!