Swedroe: Quality Factor Global In Scope

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 30^th and 70^th 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:

• A simple strategy that is long stocks with high earnings quality and short stocks with low earnings quality produces a higher Sharpe ratio than the overall market or similar strategies betting on value or small stocks.
• The value premium was the largest at 4.9 percent, followed by the market premium at 4.0 percent, and the quality premium at 2.8 percent. The size factor was slightly negative for the period (-0.5 percent). The positive excess returns are statistically significant for quality (t = 3.38) and value (t = 2.73), but not the overall market.
• The market factor was the most volatile, with 16 percent annualized volatility, followed by size and value at 8 and 9 percent, respectively. Quality is by far the least volatile, with only 4 percent annual volatility.
• While the market and value factors had the largest premiums, because they also had the largest volatilities, the highest Sharpe ratio of 0.69 was earned by the quality factor, followed by value at 0.56 and market at 0.25.
• Simple cap-weighted, long-only strategies combined with a value-quality tilt have beaten the broad market by 3.9 percentage points per year among large-cap stocks and 5.8 percentage points among small-cap stocks.
• The result holds both in the overall sample as well as in the more recent time period since 2005.
• Because the global earnings quality portfolio has a negative correlation with a value portfolio, an investor wishing to invest in both exposures can achieve significant diversification benefits—the Sharpe ratios were much higher for the combined strategies.

The authors also tested for various measures of quality including factors based on:

• Return on equity (ROE), going long the top 30 percent of high-ROE firms and short the bottom 30 percent of low-ROE firms.
• Cash flow to assets, going long the top 30 percent of firms with high cash flow to total assets and short the bottom 30 percent.
• Debt-to-assets factor (leverage), going long firms with low leverage and short firms with high leverage because low leverage leads to more stable earnings and less dependence on the current financing conditions in the economy.

Each factor produced a premium, with cash-flow-to-assets exhibiting the best absolute performance, followed by accruals, return on equity and low leverage. Since multiple quality metrics exhibit positive performance, the authors also examined whether a composite quality factor improved results. They found that a composite index did improve results.

Summary

There’s now an extensive body of research demonstrating the existence of a return premium on earnings quality. This paper adds to evidence by presenting an out-of-sample test that confirms that the effect has been prevalent in international markets as well, reducing the likelihood that earnings quality is a result of data mining.

In my next post, I’ll explore the effect of the quality premium in emerging markets.

Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.