There’s a wide range of “quality factor” investing out there. How can the investor distinguish between the variety of methods? More importantly, how can the investor select the best factor method for given economic conditions?
To answer this question, a recent paper compared the variety of methods, and examined how each method performed under different market conditions. The paper, “What is Quality?”, by Jason Hsu, Vitali Kalesnik, and Engin Kose, won the Graham & Dodd 2020 award for the best paper published in the Financial Analysts Journal in 2019.
To celebrate the achievement, the journal invited the authors of the paper to speak about their findings at a webinar hosted by the Chartered Financial Analysts (CFA) Institute on July 15, 2020, with a Q & A afterward. The moderator was Stephen J. Brown, Professor of Finance, Monash Business School.
Jason Hsu posed the question: “What is quality?” He is the Founder, Chairman, and CIO of Rayliant Global Advisors. “Quality is an industry term that refers to the combination of company characteristics that are associated with firms that generate superior returns.” It contains several underlying drivers.
In addition to a recap of their award-winning paper, Hsu and Kalesnik responded by offering an update. They looked at the various “quality factors” available, explained their basic findings, and applied them to the Covid-19 crisis and ESG metrics.
“Quality is a catch-all,” said Hsu, so there was a lot of sorting to do. They classified the different quality definitions in seven buckets:
- Growth in profitability
- Payout/dilution
- Profitability
- Earnings stability
- Accounting quality
- Investment
- Capital structure
For example, one of these quality-factor buckets, “Profitability,” contained several components: operating profitability; gross profitability; return on equity (ROE); return on assets (ROA); return on invested capital (ROIC); cash flow profitability; and gross margins.
Hsu described how they looked at the robustness of each of the seven buckets. They applied three criteria: 1) was the quality factor method cited by other journals? 2) was it robust to perturbations – or did it fall apart? And 3) was it robust across geographies? The authors found the quality definitions were robust – except for capital structure.
“Profitability and investment have the most academic evidence,” Hsu said. “In 2015 Fama and French added these two factors to their three-factor model.”
Outside of Japan, they found that four buckets (profitability, investment, accounting quality, and payout/dilution) all displayed robust performance.
The remaining three buckets (earnings stability, growth in profitability, and capital structure) were types of quality factors that did not merit a premium.
Quality factors and economic crises
“It’s important to look under the hood,” said Vitali Kalesnik before he summarized the application of the different quality factors to different economic times. Kalesnik is a Partner at Research Affiliates.
First, he applied the tried-and-true “profitability” and “investment” quality factors during six bear-market periods. “We found quality tends to underperform in bear markets.”
However, in the two-year period following bear-market shocks, quality factors overperformed – and stayed that way for the full period of the business cycle.
In the Covid-19 lockdown, Kalesnik sees the same pattern: “quality factors underperform at the start of this market downturn.”
Quality factors and good governance
Hsu and Kalesnik looked at ESG metrics and quality factors. (ESG refers to the environmental, social and corporate governance of companies.)
In companies that have good ESG practices, “leaders aim to generate sustainable long-term performance,” Kalesnik said, “rather than making decision to benefit managers in the short run.”
The researchers found four measures of good governance that are aligned with long-term value creation and sustainable growth:
a) Accounting accruals – “Avoid companies that manipulate their earnings.”
b) Investment – “Avoid empire builders.”
c) Issuance – “Avoid dilution and companies relying on external capital.”
d) Profitability – “Avoid badly run or unprofitable businesses.”
“From the ESG perspective,” Kalesnik concluded, “these four measures can help investors combine the preference for improved returns with the desire for good governance.”
Sounds like a win-win solution. ♠️