By Jack Forehand, CFA, CFP® (@practicalquant) —
There has always been an interesting dichotomy with the quality factor.
On one hand, individual investors typically consider it the most sensible factor and it is the one they are most naturally drawn to. And that makes complete sense. When you suggest value to investors, they typically point out that most value stocks are not the greatest companies. When you suggest momentum, they wonder why they would buy a stock just because it has gone up. When you suggest low volatility, you get similar concerns about it not being tied to company fundamentals. But when you suggest investing in quality businesses, investors seem to be almost universally attracted to the idea.
On the other hand, quality is typically one of the least loved factors among quants. I know I personally struggle with it a lot. The reason is that for a factor to work, we typically want to see either a risk-based or a behavioral explanation for why it should work. And it is difficult to argue that high quality stocks are riskier than the market, or that there is a reason that investors would systematically misprice them.
Part of the issue with quality is that it typically means different things to different people. Quant investors like me try to identify the specific metrics that best define quality and use them to build investment strategies. Discretionary investors, on the other hand, tend to take a more in-depth approach and rely less of specific definitions.
But either way, the first step in trying to run any strategy that seeks to utilize quality is figuring out how to define it, and how to take that definition and put in into practice.
The Varying Definitions of Quality
Rather than using this article to try to settle on a specific definition of quality, I thought I would instead look at the range of ways I have seen it done. Since I am a quant, we will start there.
Here is how quant firm AQR defines quality.
AQR Capital Management has defined the factor (QMJ, or quality minus junk) to be companies with the following traits: low earnings volatility, high margins, high asset turnover (indicating efficient use of assets), low financial leverage, low operating leverage (indicating a strong balance sheet and low macroeconomic risk) and low stock-specific risk (volatility that is unexplained by macroeconomic activity)
There is lot in that definition, but it picks up on many of the things you would think in your mind if you think about what a quality company is. Quality companies are typically very profitable. They produce consistent results. And they don’t use excessive leverage and have strong balance sheets.
But one of the challenges with all of these great attributes goes back to what I mentioned earlier. It is difficult to explain why investors would underprice these types of securities, thus allowing investors buying them an opportunity to produce an excess return.
This was a point that Jason Hsu, the co-founder of Research Affiliates and founder of Rayliant Global Advisors, addressed when he came on our Excess Returns podcast. Jason made the point that the key to defining quality in such a way that it leads to excess returns over the market may lie in finding ways to identify dimensions of quality that investors don’t appreciate. If you do can that, then my point from earlier in the article that there is no reason that investors would systematically misprice quality companies would no longer apply. Jason suggested things like firms that hold excess cash on their balance sheet as potential dimensions of quality that may not be recognized by the market.
The idea of findinq quality companies that are underappreciated by the market was also underscored by Drew Dickson of Albert Bridge Capital in his article “Peak Quality?”. Drew makes the point that a high quality company is not necessarily a high quality stock and that coupling quality with value can help avoid overpaying for quality. When you think about it, Drew and Jason are actually making similar points. Paying up for high quality companies may not work very well when the market already appreciates that quality.
Another point that those of us that are quant investors need to keep in mind is that it is certainly possible is that the best definition of quality may be one that can’t be quantified. Ryan Krueger of Freedom Day Solutions recently appeared on our podcast, and he offered a completely different take. He defined a quality business as one that will still be engaging in the same business ten years from now that it is today. That isn’t something a quant like me can back test. But it gets at the heart of what a quality business is. They should be able to stand the test of time. Maybe quality is something that can better be identified by discretionary investors than quants like me.
The Elusive Definition of Quality
So what does all of this mean?
I think the major takeaway isn’t that we can combine all of these definitions together to create some sort of master definition of quality. Instead, I think the takeaway is that quality is something that will never lend itself to that type of one size fits all definition. A high quality business to one investor is not necessarily a high-quality business to another. And avoiding the popular definitions may be a superior approach. In the end, quality may truly be in the eye of the beholder.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.