Researchers examined the attributes of the quality factor to see which showed the most reliability as a source of return premium.

The concept of quality, widely debated in professional circles, remains without a universally embraced definition. Quality factors can provide a valuable signal worthy of consideration, but they may not necessarily represent a distinct anomaly. So, what precisely constitutes quality? The study looked at seven distinct categories of attributes used by investment product providers to define quality: profitability, earnings stability, capital structure, growth, accounting quality, payout/dilution and investment.

Three methodologies were used to assess the validity of signals used in quality factors. First, the financial literature was reviewed to evaluate how widely each factor was tested for quality by economists. Second, a factor’s consistent outperformance across diverse non-U.S. geographic regions was assessed and, finally, a factor’s resilience to reasonable variations in its definition was gauged.

The study found that profitability consistently demonstrates superior performance when adjusted for risk across multiple investment factors. Accounting quality also exhibits consistent outperformance. Conversely, attributes such as earnings stability, capital structure and growth in profitability do not present compelling evidence of superior performance. Payout/dilution consistently delivers superior performance. On the other hand, the investment attribute displays superior performance when assessed through return spread and risk-adjusted returns, but it exhibits weakness on a multifactor alpha basis.

All the strongest metrics possessed a governance perspective, which the researchers note may hold relevance for investors focused on environmental, social and governance (ESG) issues. Specifically, high profitability combined with a conservative investing approach could be interpreted as a signal of strong positive governance. High accounting quality can be viewed through the ESG lens as indicative of a corporate culture characterized by compliance, transparency and integrity in financial reporting. Conversely, high payout and low dilution can be interpreted as an indicator of responsible stewardship toward equity shareholders.

Source: “What Is Quality?,” by Jason C. Hsu, Vitali Kalesnik and Engin Kose; Financial Analysts Journal, Vol. 75, No. 2 (Second Quarter, 2019).

Related

Feature

Addressing the Challenges ESG Investors Face

AAII How-To

AAII's Quality Grade Undergoes Expansion: Looking Behind the Curtain

Stock Strategies

Methods for Valuing a Stock Based on Profitability and Growth