Swedroe: Looking At Quality Factor

December 23, 2013

Is the higher price investors pay for quality stocks worth it?

Clearly, all else equal, investors should be willing to pay a higher price for stocks that are safer; that is, that are of higher quality.

Clifford S. Asness, Andrea Frazzini, and Lasse H. Pedersen, authors of the study “Quality Minus Junk,” sought to answer the question, How does the higher price investors pay for quality impact the gross and risk-adjusted returns investors earn?

The authors tested the pricing of quality for U.S. stocks for the period 1956-2012, as well as a broad sample of stocks from 24 developed markets from 1986 to 2012. To define quality stocks, they used four broad characteristics that are indicative of safer companies:

  • Profitability: Measured by such metrics as return on equity, return on assets, margins and cash flows
  • Growth: Measured by the prior five-year growth in the profitability measures.
  • Safety: Measured by both market beta and volatility, as well as by fundamental-based measures such as leverage, volatility of profitability, and credit risk
  • Payout: Management’s agency problems are diminished if free cash flows are reduced through higher net payouts (including dividends and buybacks offset by new share issuance)

The authors noted: “For the market to rationally put a price on these quality characteristics, they need to be measured in advance [emphasis mine] and predict future quality characteristics, that is, they need to be persistent.” They found this to be the case: “Profitable, growing, safe, and high-payout stocks continue on average to display these characteristics over the following five or 10 years.”

In other words, the metrics are predictive. Following is a summary of their findings:

  • While higher quality is significantly associated with higher prices, the explanatory power of quality on price is limited, as the average r-squared is only 12 percent in the U.S. sample and 6 percent in the broad sample.
  • Controlling for firm size and past 12-month stock returns, the cross-sectional r-squared increases to 31 percent and 26 percent, respectively, still leaving unexplained a large amount of the cross-sectional distribution of prices.
  • Larger firms are more expensive controlling for quality, analogous to the size effect on returns.
  • While profitability and growth are unambiguously associated with higher prices, safety is mixed, and even negative when controlling for size and past returns. Stocks with high payouts appear to command a lower, not a higher, price.
  • High-quality stocks have significantly higher raw returns than junk stocks. The difference in their risk-adjusted returns—the four-factor (beta, size, value and momentum) alphas—is even larger, since high-quality stocks have relatively lower market, size, value and momentum exposures than junk stocks.

In other words, while the returns of growth and quality are positively correlated, the incremental price paid for quality companies hasn’t been high enough.

  • Constructing a QMJ (quality minus junk) factor—the return of the top 30 percent of stocks as ranked by quality minus the return of bottom 30 percent—the authors found that QMJ delivered positive returns in 23 out of 24 countries (New Zealand, the smallest country in the sample, being the one exception), and highly significant risk-adjusted returns in both the U.S. and broader sample.
  • The abnormal returns are large in magnitude and highly statistically significant. In the U.S., a QMJ portfolio that is long high-quality stocks and short junk stocks has three-factor and four-factor abnormal returns of 68 and 66 basis points per month, respectively, with corresponding t-statistics of 11.10, and 11.20. Similarly, in the global sample, the QMJ factor earned abnormal returns of 61 and 45 basis points per month, respectively, with corresponding t-statistics of 7.68 and 5.50. In addition, the QMJ factor consistently delivered positive excess returns as well as positive risk-adjusted returns over time.




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