Quality: One factor speaks for itself

Everyone would like to have “good” stocks in his or her portfolio. But what actually makes for a good stock? For stocks with a high “quality” factor, the name says it all. Those stocks combine security and consistency with an attractive return, and they seemingly turn finance theory on its head. But investors shouldn’t lose their heads over them. There is no such thing as a free lunch, so quality stocks should only be one part of an investor’s menu.

 

A matter of definition

What actually makes for a “good” stock? Many an investor may have asked him- or herself that question at one time or another. The answer to it, like so much else in life, lies in the eye of the beholder. A “good” stock could be a very inexpensively valued one or one that pays out a high dividend yield. Many an investor would like the lowest possible volatility in his or her portfolio or prefers stocks with good momentum. For other investors, robust enterprise growth is the only thing that matters – in the hope that the company’s share price will also grow robustly. All of the aforementioned attributes are (equity) “factors”, in investment parlance. They are characteristics that help explain a stock’s long-term risk/return profile. One factor that’s missing in the list above and which comes closest to what one would presumably associate with a “good” or high-quality stock is the factor “quality”, which describes companies that have a stable business model and a sustainable competitive advantage. Quality companies typically carry little or no debt, have steady earnings, and are highly profitable. The name says it all, so to speak – even in tough stock-market periods because quality stocks rank as defensive and tend to lose less than the broad index during phases of general market weakness. Pharmaceuticals giant Novo Nordisk, major semiconductors player ASML, and luxury goods group LVMH are examples of enterprises considered typical quality companies in Europe. IT titans Apple and Microsoft and payment services provider VISA are prominent examples in the USA.

 

Almost a free lunch | High return with relatively low volatility

Risk/return profile of different factors (since 2000)

Sources: Bloomberg, Kaiser Partner Privatbank

 

Delivers what the label says

A stock “of high quality” should of course ideally also perform well, i.e. better than average. And in fact, the “quality” factor has indeed outperformed by a wide margin since the year 2000, generating a substantial excess return of 2 percentage points per annum relative to the MSCI World index (+7.1% vs. +5.1%). The factor indices published by index provider MSCI serve as the basis for the above calculation. To capture the quality factor and to identify quality stocks, MSCI screens the equity universe for three fundamental variables: return on equity, debt to equity, and earnings variability (how consistent earnings growth has been over time). The consistent alpha that quality stocks generate seemingly stands in contradiction to finance theory, according to which higher risk should be compensated with a higher return. That’s the way it is, for example, on the bond market, where high-yield bonds are riskier than investment-grade bonds. High-yield bonds are more volatile than their investment-grade counterparts and can exhibit relatively bigger drawdowns over the course of their life, but in exchange deliver a higher return in the long run. However, it’s exactly the other way around with the “quality” factor on the equity market: (“junk”) stocks that fail to meet the aforementioned quality criteria exhibit higher price volatility and deliver lower returns than genuine “quality” stocks do.

 

Topsy-turvy investment world | When higher quality yields a better return

Risk/return profile of bonds vs. stocks

Sources: GMO, Bloomberg, Kaiser Partner Privatbank

 

The cause of the anomaly opportunity

The “quality” factor has been well-known for quite some time. Robert Novy-Marx paved the way for its widespread dissemination in academic literature in 2012. His pioneering study1 found that a company’s profitability and stability are just as useful as the much better-known “value” factor for explaining stock-price performance. In 2015, Nobel laureates Eugene Fama and Kenneth French broadened their three-factor model for explaining stock returns by adding the factors “profitability” and “asset growth” (a measure for conservative or aggressive investment behavior). Frazzini, Kabiller, and Pedersen2, in turn, demonstrated that the success achieved by Warren Buffett, who is primarily known as a value investor, is attributable not just to the “value” factor, but equally owes to his focus on safe “quality” stocks. A vast amount of academic ink has been spilled in theorizing an explanation for this apparent anomaly. One relatively simple hypothesis holds that investors are willing to pay a premium for the positive attributes of “quality” stocks (for their safety, for example). And in fact, stocks with a high “quality” factor are consistently more expensive than the “average” stock. Another hypothesis postulates that analysts and investors systematically underestimate the future returns on shares of high-quality companies. They prefer to bet on spectacular lottery-like stocks with fragile business models while ignoring boring but stable companies and their shares. According to this theory, this misappraisal is the fount that harbors alpha potential, and to this day is hasn’t run dry yet. Although the “quality” phenomenon has been well-known for a long time, the opportunity that it presents on the equity market still exists today. Studies3 show, for example, that a long-short portfolio composed of “quality” (long) and “junk” (short) stocks can constitute a strategy with attractive risk/return characteristics. The “quality” factor’s star is shining exceptionally brightly at the moment. Practically regardless of the starting date used to pit the different MSCI factor indices against each other in a performance comparison, the “quality” factor leads the pack in most cases (from 2000, 2010, and 2020 onward, for example).

Outperformance | Quality is in demand at the moment

Performance of different factor indices

Source: Bloomberg, Kaiser Partner Privatbank

 

Choose the menu with caution

The “quality” factor, moreover, is also benefiting from the current euphoria surrounding the artificial intelligence theme, in part because some of the big, fast-growing (US) technology companies have developed in recent years into highly profitable earnings-generating machines that perform reliably (almost) regardless of the ups and downs of the economic cycle. Consequently, some former “growth” companies have since also become “quality” companies at the same time. This is also reflected in the respective MSCI factor indices, in which companies like Apple, Microsoft, Alphabet, and Meta feature prominently on both the “growth” and “quality” rosters. After the halfway point of 2023, “growth” and “quality” are both way out in front in the factor rankings with a performance above +20%. However, despite the good track record over both the short and long term, investors shouldn’t put all of their eggs in the “quality” basket. That’s because even though the “quality” anomaly looks set to continue presenting opportunities in the long run, one should never forget one of the most important lessons for investors, the tenet that diversification is and remains essential, including in factor investing, because fashions can change (repeatedly). For example, in the middle of the 2000s decade, even the “quality” factor experienced a lengthy dry spell. We currently do not detect any immediate macroeconomic or market drivers that could trigger a recurrence of such a long phase of (relative) weakness. However, in the medium term we also see good investment opportunities elsewhere, particularly in the “size” factor. At the moment, small-cap stocks in both the USA and Europe are very inexpensively valued in historical terms relative to large caps. This valuation gap could close again over the next two to three years. So, against this backdrop, dedicated small-cap strategies or, alternatively, the MSCI Equal Weighted index also belong on the investor menu.

 

2 in 1 | Quality and growth at once

Top 10 companies in factor indices

Sources: MSCI, Kaiser Partner Privatbank

 

No free lunch after all | Fashions can change

Performance heat map for factor indices

Sources: Bloomberg, Kaiser Partner Privatbank

 

1) Novy-Marx, R. (2012): “The Other Side of Value: The Gross Profitability Premium”

2) Andrea Frazzini, David Kabiller, Lasse H. Pedersen (2013): “Buffett’s Alpha”

3) Including, for instance, Clifford S. Asness, Andrea Frazzini, Lasse H. Pedersen (2013): “Quality Minus Junk”

 

Oliver Hackel, CFA Senior Investment Strategist

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