Swedroe: Differing Definitions Of Quality

August 05, 2016

The 1997 publication of Mark Carhart’s paper, “On Persistence in Mutual Fund Performance,” led to the four-factor model (which added momentum to market beta, size and value) becoming the workhorse model in finance. The next major contribution came from Robert Novy-Marx. His 2012 paper, “The Other Side of Value: The Gross Profitability Premium,” provided investors not only with new insights into the cross section of stock returns, but it helped further explain Warren Buffett’s superior performance.

Researchers have since extended the profitability factor to a broader quality factor (the returns to high-quality companies minus the returns to low-quality companies) that captures a larger set of quality characteristics. While there is not yet one consistent definition of quality, in general, high-quality companies have the following traits: low earnings volatility, high margins, high asset turnover (indicating the efficient use of assets), low financial leverage, low operating leverage (indicating a strong balance sheet and low macroeconomic risk) and low specific stock risk (volatility unexplained by macroeconomic activity).

Companies with these characteristics historically have provided higher returns, especially in down markets. In particular, high-quality stocks that are profitable, stable, growing and have a high payout ratio outperform low-quality stocks with the opposite traits.

Mutual fund companies have been active in developing investment vehicles that provide access to this new factor. And cash flows have followed. Quality is among the hot “smart beta” strategies into which investors are pouring assets.

Academics Vs. ‘The Industry’
Georgi Kyosev, Matthias Hanauer, Joop Huij and Simon Lansdorp contribute to the literature on the quality factor with their June 2016 paper, “Quality Investing — Industry versus Academic Definitions.” Their data sample covers developed and emerging market stocks starting from December 1985 and December 1992, respectively, until December 2014, and an average of about 1,600 stocks from the FTSE World Developed Index and from the S&P/IFC Investable Emerging Markets Index.

The authors chose to limit their universe because “many return anomalies are known to disappear or become significantly less pronounced when the universe is restricted to large-caps.” Thus, they restricted their emerging market universe to the 500 largest stocks.

In their analysis, the authors created two categories of quality companies. The first category they referred to as “industry” quality. Based on their review of fund prospectuses, index methodologies and research notes, the authors selected a representative but nonexhaustive list of “industry” variables consisting of return on equity (ROE), earnings to sales (margin), 12 months’ growth in return on equity (ROE growth), total debt to common equity (leverage) and volatility of earnings growth (earnings variability). The second category they referred to as “academic” quality. Based on robust documentation in the academic literature, they selected:


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