The quality factor has demonstrated long-term outperformance against the market, but it has not received the same attention as the value, size or momentum factors. This neglect comes despite quality’s pedigree: Benjamin Graham asserted that careful analysis of company fundamentals such as profitability track record, earnings stability and balance sheet strength is important in determining an investment’s “margin of safety” — that is, ensuring that one buys a stock at an adequate discount to its intrinsic value.
The quality of a company can generally be evaluated along five key dimensions: Profitability, Earnings Quality, Financial Leverage, Asset Growth and Corporate Governance.
5 Key Dimensions of Quality
These five dimensions provide insights into a company’s quality characteristics from different perspectives. Profitability and Earnings Quality are income statement related measures of quality, while Financial Leverage and Asset Growth are linked to the balance sheet of the company. Finally, Corporate Governance goes beyond purely financial measures of quality and takes into account corporate policies.
Various descriptors can be used to define each of these dimensions. Institutional investors can replicate a variety of quality indexes with these descriptors, depending on their objectives and their capacity requirements:
A classic approach can be found in the MSCI Quality Index, which is constructed using Return-to-Equity (ROE), Debt-to-Equity (D/E) and Earnings Variability (EV).
Investors who are concerned about excessive sector biases can adopt a sector-neutral approach.
Investors who require high investment capacity may consider a tilting approach, which historically has tended to display lower exposure to the quality factor compared with the MSCI Quality Index.
Quality has also been an effective diversifier to other factors historically. Our research shows that quality displayed low or negative correlations with other systematic factors, especially value and low size from December 1998 – December 2014. In addition, the MSCI World Quality Index has exhibited a similar defensive characteristic as the MSCI World Minimum Volatility Index in high volatility regimes. However, the MSCI World Quality Index tended to have a higher exposure to large-cap stocks and low leverage stocks, which are generally sought-after attributes when a flight to quality occurs.
We also explored alternative approaches to quality. The new Barra US Total Market model’s management quality factor (a stand-in for Asset Growth) is an additional dimension of quality and produced encouraging results in our analysis. And by adding corporate governance indicators, we examined an approach that targets long-term sustainable performance.
Read the full paper, “Flight to Quality: Understanding Factor Investing."