A Guide to Quality Factor Investing

• Date : August 16,2023

A builder who wants to construct a durable house will prioritize using high-quality materials, such as a strong foundation, sturdy structure, and reliable electrical and plumbing systems. In modern language, 'quality' is mostly associated with excellence. When we describe something as a 'quality product', we typically mean that it is of high quality. Just as high-quality constructions can provide superior safety, durability, and customer satisfaction, quality investments can provide better long-term returns and help investors achieve their financial needs.

What is quality factor investing?

Quality factor investing is an investment strategy that focuses on identifying high-quality companies. Companies with greater control over their peers in terms of purchase and sales, with lower costs and a high degree of financial and strategic flexibility are defined as quality companies. 

"Investing in high-quality businesses at reasonable prices is a winning strategy for the long-term." - John Paulson
 

How is quality measured?

Just as the quality of clothes can be measured with the fabric used, the quality of a company can be determined through its financial statements such as its income statement, balance sheet and cash flow statement along with certain fundamental ratios such as return on equity, return on assets and gross margin among others. Over the long term, stocks of companies with stronger financial statements, stable earnings and higher margins outperform low-quality companies. 

The feature that distinguishes quality from other factors is its lack of dependence on the prevailing stock price. Its evaluation is predicated upon non-market information, primarily the periodic financial disclosures released by firms. Measuring the quality factor is quite challenging since quality is subjective and a ‘one size fits all’ model can’t be adopted to measure quality. While some may consider companies with high gross and operating margins to be of superior quality, others may give more importance to low leverage and high Return on Equity (ROE).

Despite the subjectivity involved in measuring the quality of a company, companies that increase profits regularly and sustainably, keep costs stable, and maintain a healthy balance sheet are given the tag of high quality. With these characteristics as parameters, asset managers make certain rules and invest in those companies that fall under the tag of high quality.

"In the long run, a company's stock price is determined by the quality of its underlying business." - Warren Buffett
 

Benefits of quality factor investing :

The stocks that represent companies of high quality tend to perform better over the long term. Ultimately, over a longer time period, it is the companies’ financial strength, fundamentals, and profitability that boost the stock prices of a company. Empirical studies have shown that companies with high-quality outperform their low-quality counterparts in the long run (Jacob et. al, 2022). 

The quality premium:

Well-informed and rational investors are likely to be willing to pay extra for companies that have strong business fundamentals and desirable characteristics. This is often known as the Quality Premium or Quality Effect, and it suggests that high-quality stocks have the potential to perform better than lower-quality stocks over longer time frames. 

Due to the inconsistencies in measuring quality amongst different fund managers, it is difficult to gauge the quality-related premia. The quality factor seems to have a stable relationship with the index with some cyclicality in performance. Academic researchers and practitioners are constantly striving to improve the methods used to measure the quality factor, as they do with all other factors.
 

Quality factor performance overseas:

The quality factor has shown promising performance in India as well as the US. The 5-year and 10-year rolling returns of S&P quality Index are 11.01% and 10.59% respectively as compared to the 5-year and 10-year rolling returns of S&P 500 of 8.09% and 7.68% respectively. 

Source: S&P Dow Jones Indices LLC

• CAGRs are calculated as the average CAGR based on the rolling CAGRs (rolled daily) calculated for the respective holding periods i.e. 5, and 10-Yr rolling CAGRs. 

• The period for calculation is from 5th July 1995 to 31st December 2022. Data scaled to 1000 on 5th July 1995. 

• Past performance may or may not be sustained in the future and is not an indication of future return
   

Conclusion: 
To conclude, the Quality factor is an important investment strategy that evaluates companies by analyzing their fundamental characteristics such as profitability, growth potential, earnings quality, and leverage. These metrics can help asset managers measure the quality of a  company with valuable insights into a company's underlying financial strength and management competence. By using the quality factor to form rules that identify high-quality stocks, rule-based asset managers can invest in companies that have the potential to outperform over the long term.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.