Quality Sub Factors Matter

Author:

Damian Handzy
Managing Director | General Manager - Analytics at Confluence
Jim Monroe, CFA
Product Manager Confluence

Factor investing calls for identifying those stocks with the strongest characteristics for a given factor, but there is a large number of characteristics, or sub-factors, that can be used to define each factor.

The typical monthly performance spread between sub-factors within each overall factor is between 100 and 200 basis points. During large market downturns, those spreads can widen to as much as 350-370 basis points. In this research note, we focus on the Quality factor and the numerous subfactors by which it can be implemented.

Of all the factors, Quality is the most challenging to succinctly define, as practitioners use some combination of a long list of disparate metrics, each of which is in some way associated with the unfortunately vague notion of “quality.” Unlike other factors, there is no one single theme that well defines what a high “quality” stock might be. The list of Quality sub-factors includes metrics as varied as: profit-toasset ratio, ROA, ROIC, profit margin, earnings growth stability, sales growth stability, debt-to-equity ratio, and asset turnover.

We grouped these seemingly disparate Quality sub-factors into three groups: Profitability-based sub-factors, Stability-based sub-factors and Leverage-based subfactors. Among those groups we found that:

  • Profitability-based Quality sub-factors provide the highest average premium over the markets: +100 bps, on average, all of which comes from down markets.
  • Both profit-based and stability-based Quality sub-factors provide strong downside protection.
  • Leverage-based Quality sub-factors, on average, do not outperform markets in either up or down markets. They are also uncorrelated with other sub-factors.
  • For each of the three groups, just one or two sub-factors stand out as outperformers. All the other sub-factors provide market-like returns.

Table 1, below, summarizes the average performance of these three buckets from 1980 through 2020.

Table 1: Summary of Performance of the three buckets from 1980 through 2020.

Profitability-based Quality sub-factors

Profitability might be the most common characteristics when constructing Quality portfolios and is certainly the most common among Quality indices. Academics have certainly established that more profitable companies earn a return above less profitable companies. The profitability sub-factors we examined are:

  • Gross Profits to Assets: Gross Profits (revenue less cost of goods sold) is a clean estimate of economic profit because it does not remove expenses that are potentially production or competition enhancing (such as R&D, advertising and capital expenditures).
  • Gross Profit Margin: Gross Profit divided by net sales. It has similar advantages as does Gross Profits to Assets in that it does not remove expenses that may be aiding productivity.
  • Net Profit Margin: Net income before preferred dividends, divided by net sales. This measure attempts to assess the company’s potential for profitable sustained expansion / growth.
  • Operating Profit Margin: Operating income / revenue. It measures the profit of the company based on earnings before interest and tax.
  • Return on Equity: net income (after preferred dividens), divided by book value of shareholders’ equity. It measures profitability of the operations of a company as a fraction of the equity. It is a traditional measure of a company’s growth potential.
  • Return on Assets: After-tax net income (including interest expense) divided by 2-year average asset value. ROA measures profit based on net income generated from its assets.
  • Return on Invested Capital: After-tax net income (including interest expense) divided by 2-year average total capital plus current interest. ROIC measures profitability based on operating income as a fraction of total invested capital.

Figure 1 shows a comparison of each of these sub-factors’ returns from over the past 41 years, since 1980. While all of these profitability-based subfactors outperform the broader market over this period, all but one of them remain in a band that’s valued at 40% to 60% above the starting point.

Figure 1: Cumulative performance of US Quality portfolios calculated by investing in the top quartile of stocks defined by the single profitability-based sub-factors. All performance is relative to a basket of the 3,000 largest capitalized US stocks.

The one outlier is the ratio Gross Profits to Assets. We also note that the worst performing sub-factor is Gross Profit Margin, leading us to conclude that companies with smaller asset bases have done particularly well in this period. Gross profits are sometimes preferred because they don’t remove R&D from the calculation. The gross profits to assets ratio combines two important features: it includes R&D in the numerator and explicitly measures profit as a fraction of assets, rewarding companies with smaller asset bases that spend more on R&D. It therefore singlesout high-tech companies that have performed particularly well over the past four decades.

Profitability measures provided the highest overall market performance of the three buckets (Table 1) because, as a group, they provide positive returns in down markets while not lagging the markets when they are up.

Stability-based Quality sub-factors

Stability measures purport to provide a degree of quality based on the idea that consistency in financial reporting is a characteristic of well-managed companies and that such stability leads to more pronounced performance. We examined the following stability-based Quality sub-factors:

  • Sustainable Growth Rate: ROE * (1-Dividend per Share/Earnings per Share). If the company can maintain its current ROE, this number provides a measure of how much of its earnings are re-invested in the company and therefore should result in growth.
  • Low Accruals: Measured as the ratio of accruals to assets. Accruals are an overhang on the balance sheet from one accounting period to the next, and are associated with loose management practices and are a possible sign of earnings figures manipulation.
  • Earnings Growth Stability 5 year: Inverse (negative) of the standard deviation of earnings growth over the past 5 years.
  • Sales Growth Stability 5 year: Inverse (negative) of the standard deviation of sales growth over the past 5 years.
  • Earnings Growth Stability: Inverse (negative) of the standard deviation of earnings growth over the past 3 years.
  • Sales Growth Stability: Inverse (negative) of the standard deviation of sales growth over the past 3 years.

Figure 2: Cumulative performance of US Quality portfolios calculated by investing in the top quartile of stocks defined by the single stability-based sub-factors. All performance is relative to a basket of the 3,000 largest capitalized US stocks.

Unlike the profitability-based Quality sub-factors, all of which provided higher returns than the market, only two stability-based sub-factors did so: Sustainable Growth Rate and 5-year Earnings Growth Stability. Curiously, the Sales Growth Stability sub-factor, which is computed over 3-years, offered a much weaker performance than the same measure computed over 5-years.

The Sustainable Growth Rate can be thought of as the highest growth rate a company can maintain without having to finance additional growth through equity or debt issuance. Companies with high sustainable growth rates are usually those that have highly productive sales of highmargin products. Note that it does now take into account stock price and is therefore not at all associated with valuation.

Stability-based Quality sub-factors provided market outperformance in down markets (+5.5%) but lagged the market in up markets (-2.2%) as shown in Table 1. Overall, they provided just 30 basis points of market outperformance over the 41 year time period we examined, and had a high enough tracking error to warrant a near-zero information ratio.

Leverage-based Quality sub-factors

High leverage is associated with risky management and therefore low leverage is considered a characteristic of Quality companies. We examined the following leverage-based Quality sub-factors:

  • Asset Turnover: Net sales to total assets ratio. This measures how efficient a company is at deploying its assets to generate revenue.
  • Assets to Equity: total assets to total equity ratio gives an indication of how much leverage has been used to finance the company.
  • Current Ratio: the ratio of current assets to current liabilities. It indicates a company’s ability to meet its obligations over the coming year.
  • Quick Ratio: The ratio of cash + marketable securities + accounts receivable to total short-term liabilities. It indicates an ability to meet short-term liabilities.
  • Low Gearing / Low Deb-to-Equity: the inverse (negative) of the debt-to-equity ratio. Companies with low gearing are less burdened by debt repayment.

Figure 3: Cumulative performance of US Quality portfolios calculated by investing in the top quartile of stocks defined by the single leverage-based sub-factors. All performance is relative to a basket of the 3,000 largest capitalized US stocks.

As shown in Figure 3, the only leverage-based sub-factor to outperform the market is Asset Turnover, which posted a cumulative return similar to the highest profitability-based and the highest stability-based subfactors. The other factors in this group provided market-like returns. We note that the highest Asset Turnover companies are those with strong sales and low asset levels, which, like the best performing profitabilitybased sub-factor, favors software and high-tech companies over the previous two decades. In fact, Figure 3 shows the Assets-to-Equity performance to be flat until after the tech bubble collapse and all of its growth has been in the past 20 years.

According to Table 1, the leverage-based group on average produced unremarkable and very market-like returns with high tracking error. It produced very market-like returns in both up and down markets.

Correlations between Quality sub-factors

We also examined the correlations between the sub-factor returns and between he three groups of sub-factors, presented in the table below:

Table 2: Correlations between the three groups of Quality sub-factors over the period from 1980 through 2020.

There are several things to note about the correlations:

  • Within each group, the profitability-based sub-factors are most strongly correlated with each other at 0.5, and the stability-based sub-factors are also positively correlated with each other but to a lesser degree: 0.3.
  • Leverage-based sub-factors have no correlation, or slightly negative correlation, with each other (-0.07), essentially acting each on their own.
  • Between groups, we find that profitability-based sub-factors are just as correlated with stability-based sub-factors as stability-based subfactors are correlated with each other!
  • Leverage-based sub-factors are also uncorrelated with any other types of Quality sub-factors.

Conclusions

Our analysis above leads us to several overall conclusions about Quality sub-factors:

  • Profitability-based and stability-based sub-factors offer the strongest evidence of market outperformance over the past 40 years. In particular, Gross Profits to Assets, Sustainable Growth Rate and 5-year Earnings Growth Stability have posted the strongest returns.
  • Quality investing (through profitability and stability based sub-factors) provides meaningful downside protection (Table 1) but has not demonstrated outperformance in upside markets.
  • Leverage appears to provide neither upside nor downside benefit over the market and is uncorrelated with itself and the other measures of Quality. We question the validity of considering leverage-based subfactors in a meaningful definition of Quality investing.

    • Next steps

    Quality investing is often combined with other factor / style investing strategies, and our plans are to investigate the degree to which Quality sub-factors matter as part of a multi-factor strategy such as Quality-Growth and Quality-Value.

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