- Gross profitability: Revenue minus cost of goods sold
- Accruals: Firms with high accruals earn abnormally lower average returns than firms with low accruals, because investors overestimate the persistence of the accrual component of earnings when forming earnings expectations.
- Net stock issues: Net stock issuance and stock returns are negatively correlated as smart managers issue shares when sentiment-driven traders push prices to overvalued levels.
Separating stocks into quintiles, the authors constructed equal-weighted, long/short (long the top quintile and short the bottom quintile) portfolios for the two quality measures (industry and academic) and rebalanced monthly. Following is a summary of their findings on the industry quality measures:
- All five industry quality measures produced positive returns for the top-bottom portfolios, with the most commonly used metric (ROE) showing the largest premium at 3.1% (with a t-statistic of 1.5). The equal-weighted industry measure produced a premium of 2.3% (with a t-statistic of 1.1). However, none of the premiums were statistically significant at the 5% confidence level.
- Controlling for the four factors (market beta, size, value and momentum) in the Carhart model, the strongest variable, ROE, had positive loadings on the value and momentum factors and an alpha of 2.6%. But with a t-statistic of 1.5, it was not statistically significant at the 5% confidence level. The combined “industry” quality strategy also loaded on value and momentum and produced an alpha of 3.1%, with a t-statistic of 1.9 (close to being statistically significant at the 5% confidence level). The one quality variable that stood out was earnings variability, with a statistically significant alpha of 3.5% (and t-statistic of 3.0). Its market beta loading of -0.3 (with a t-statistic of -11.7) hints that it behaves like another well-known effect, low beta (or low volatility).
Following is a summary of the authors’ findings on the “academic” quality measures:
- Each of the academic characteristics has positive returns that are statistically significantly: 3.6% (with a t-statistic of 2.5) for gross profitability, 3.7% (with a t-statistic of 3.0) for accruals and 4.0% (with a t-statistic of 2.3) for net stock issues. The combined “academic” quality definition clearly benefits from diversification, as it has better performance (a premium of 6.2% with t-statistic of 4.2) than each individual characteristic with comparable volatility.
- The “academic” definitions remain strong after accounting for exposure to other risk factors, as each individual factor has a highly significant alpha.
- An investor can also achieve performance improvement by diversifying across multiple quality signals. The “academic” quality strategy has an alpha of 6.9% (t-statistic of 6.26), substantially higher than gross profits, accruals or net stock issues alone.
- The academic quality factor is superior to the industry one.
These findings were confirmed in the data for non-U.S. developed as well as emerging markets. Whether looking at raw returns or at risk-adjusted alphas, “academic” consistently outperforms “industry.”