The ‘quality’ factor came later than others, but it appears to be viable around the world, Swedroe says.
William Sharpe and John Lintner are typically given most of the credit for introducing the first formal asset pricing model, the capital asset pricing model (CAPM). CAPM provided the first precise definition of risk and how it drives expected returns.
The CAPM looks at returns through a “one-factor” lens, meaning the risk and return of a portfolio is determined only by its exposure to beta—the measure of the equity-type risk of a stock, mutual fund or portfolio, relative to the risk of the overall market. CAPM was the finance world’s operating model for about 30 years. However, all models, by definition, are flawed or wrong. If they were perfectly correct, they would be laws, like we have in physics.
In 1993, Eugene Fama and Kenneth French proposed a new asset pricing model, which became known as the “Fama-French Three-Factor Model.” This model proposes that along with the market factor of beta, exposure to the factors of size and value explain the cross section of expected stock returns.
1997, Mark Carhart augmented the Fama-French three-factor model with a fourth factor—momentum. This new factor made a large contribution to the explanatory power of the model. The four-factor became the workhorse model for academic research.
In recent years, there has been a developing body of evidence that quality was another factor that helps explain returns. Among the important papers on the subject is the June 2012 study by Robert Novy-Marx, “The Other Side of Value: The Gross Profitability Premium.” The study provided new insights into the cross section of stocks returns—showing that profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios (higher price-to-book ratios).
Max Kozlov and Antti Petajisto, authors of the 2013 study “Global Return Premiums on Earnings Quality, Value, and Size,” provide us with an out-of-sample test on the existence of a return premium on stocks with high earnings quality using a broad and recent global data set covering developed markets from July 1988 through June 2012. Big stocks were defined as the largest stocks that make up 90 percent of total market cap within the region, while small stocks make up the remaining 10 percent.
Value and growth were defined by the 30th and 70th percentiles by book-to-market. The high-quality firms are characterized by high cash flows (relative to reported earnings); while the low-quality firms are characterized by high reported earnings (relative to cash flow). The following is a summary of their findings: