Swedroe: Getting To The Cause Of Quality

July 29, 2016

Among the hot “smart beta” strategies into which investors are pouring assets is quality. For example, the iShares Edge MSCI USA Quality Factor ETF (QUAL | A-84), which is only about three years old, already has $2.7 billion in assets. Before you consider investing in these increasingly popular strategies, however, it’s worth understanding the sources of their returns. That, in turn, raises an important question: Is the quality factor risk-based, or is it a behavioral anomaly?

Robert Novy-Marx’s 2012 paper, “The Other Side of Value: The Gross Profitability Premium,” provided investors with new insights into the cross section of stock returns. His study built upon the 2007study “Profitability, Investment and Average Returns” by Eugene Fama and Kenneth French, who had shown that firms with high profitability measured by earnings have high subsequent returns after controlling for book-to-market ratio and investment.

Profitability Findings
Novy-Marx investigated gross profits (defined as sales minus cost of goods sold) over the period 1962 through 2010. Among his important findings were:

  • Profitability, as measured by gross profits-to-assets, has roughly the same power as book-to-market ratio (a value measure) in predicting the cross section of average returns.
  • Surprisingly, profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios (for instance, higher price-to-book ratio).
  • Profitable firms tend to be growth firms, and they expand comparatively quickly. Gross profitability is a powerful predictor of future growth as well as of earnings, free cash flow and payouts.
  • The most profitable firms earn average returns of 0.31% per month higher than the least profitable firms. The data is statistically significant, with a t-statistic of 2.49.
  • The returns data is economically significant even among the largest, most liquid stocks.
  • Gross profitability has far more power in predicting the cross section of returns than earnings-based measures of profitability.
  • High asset turnover (defined as sales divided by assets, an accounting measure of operating efficiency) primarily drives the high average returns of profitable firms, while high gross margins are the distinguishing characteristic of “good growth” stocks.
  • Controlling for profitability dramatically raises the performance of value strategies, especially among the largest, most liquid stocks. Controlling for book-to-market ratio improves the performance of profitability strategies.
  • Strategies built on profitability are growth strategies, so they provide an excellent hedge for value strategies. Adding profitability on top of a value strategy reduces its overall volatility.

Since the publication of Novy-Marx’s work, the profitability factor has been extended to a broader quality factor (the returns to high-quality companies minus the returns to low-quality companies), which captures a larger set of quality characteristics. 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 characteristics.

The quality factor is referred to as quality minus junk. For the period 1927 through 2015, the quality premium had an annual average return of 3.8%. In addition, it was slightly more persistent than the value premium, and only slightly less persistent than the market beta premium.

A Risk-Based Or Behavioral-Based Explanation?

The academic research provides at least some support for both risk-based and behavioral-based explanations for the profitability premium. A problem for risk-based explanations is that, intuitively, more-profitable firms are less prone to distress and have lower operating leverage than unprofitable firms. These characteristics suggest they are less, not more, risky.

On the other hand, more profitable firms tend to be growth firms, which have more of their cash flow in the distant future. More distant cash flows are more uncertain, and should require a risk premium. Another risk-based explanation is that higher profitability should attract more competition, thus threatening profit margins. That, too, creates more risk and should require a risk premium.

Jean-Philippe Bouchaud, Stefano Ciliberti, Augustin Landier, Guillaume Simon and David Thesmar contribute to the literature on the quality factor with their paper, “The Excess Returns of ‘Quality’ Stocks: A Behavioral Anomaly,” which was published in the June 2016 issue of the Journal of Investment Strategies.


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