Swedroe: Quality Works On EM Stocks Too

The quality premium is real, but does it also apply to emerging markets?

My last post showed that the quality (or profitability) premium provided valuable insights into not only U.S. stock returns, but international developed markets as well. Today I’ll look at the question of whether this quality factor applies to emerging markets. The simple answer is yes.

To review, the profitability/quality factor tells us that more profitable firms outperform less profitable ones even if the more profitable firms have higher valuations than the less profitable ones, and we do have fresh research on the question of the emerging markets.

A December 2013 study by Pimco’s Masha Gordon and Giuliano De Rossi examined the data on the countries in the MSCI Emerging Markets Index to determine if there was also a profitability premium in emerging markets. The study covered the period January 1998 to September 2013. Following is a summary of their findings:

• Profitability persists. It’s sticky—both on a one- and three-year basis, there is a low probability that a highly profitable firm will migrate from a high quintile to a low quintile. This is consistent with evidence from the U.S. markets.
• The annual return on an equal-weighted, long high-return-on-equity (ROE)/short low- ROE strategy was 5.1 percent, and was statistically significant at the 10 percent level, for a t-statistic (t-stat) of 1.7. (A t-stat is a ratio of an estimated parameter from its notional value and its standard error, according to Wikipedia.) The relatively short time span available for emerging market data makes it difficult to achieve high t-stats. The Sharpe ratio was 0.41. On a return-on-invested-capital (ROIC) basis, the premium was 3.6 percent, with a t-stat of 1.2, and a Sharpe ratio of 0.29.
• In terms of gross profitability, which research suggests may best be measured as revenues minus cost of goods sold, the premium was a statistically significant 9.0 percent (tstat = 2.79). The Sharpe ratio also improved to 0.71. Note that the emerging market equity premium during the period was 6.68. Thus, the quality premium was larger than the equity premium.
• The gross profitability premium outperformed the value (based on price-to-book), size and momentum premiums, and had higher Sharpe ratios.

Profitability, or quality, strategies also provide diversification benefits, as they tend to be negatively correlated with the value and size premiums—profitable companies tend to be large and growth-oriented—though they are positively correlated with momentum.

This study adds to the growing body of evidence that the profitability/quality factor provides important explanatory power to portfolio returns.

And for investors, the takeaway is this: The quality/profitability factor should play a role in portfolio design.

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