Blog Posts — July 26, 2018

The Quality Factor

Strong balance sheets, established businesses, higher return-on-equity and superior profitability. These are the primary characteristics investors look for when it comes to so-called ‘quality’ stocks, reckoning these companies will be able to weather volatility better and outperform in the long run.

These variables contrast with other fundamental profiles and style strategies such as ‘value’ (low price-to-earnings), or ‘growth’ (faster-than-average earnings expansion potential).

A quality strategy is traditionally considered a defensive approach, favored in periods of economic contraction and during market upsets, such as after the burst of the dot-com bubble at the end of the 1990s.

Quality investing goes back to Benjamin Graham. Although commonly known as the father of value investing, Graham also focused on a company’s financial strength, and was one of the first to start sorting stocks by quality in the 1930s. As his most famous student, Warren Buffett, has put it: ‘It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’1

Focus on a quality track record

Most recently, quality strategies gained traction following the subprime crisis that brought banks‘ poor financials to light and made stocks with solid accounts all the more attractive.

Since then, quality strategies have proved quite successful. The iSTOXX® Europe Quality Factor Index, part of the iSTOXX® Europe Factor Indices family, has outperformed the broader market every single year from 2008 to 2017.2

The iSTOXX Europe Quality Factor Index recorded its largest leads over the benchmark STOXX® Europe Total Market Index in years that called for a more conservative stance: in 2013 (+29.7% vs. +21.1%), during the Eurozone debt crisis; and in 2015 (+18.3% vs. +9.7%), amid investors’ concerns over rising US interest rates.

Harnessing a tried-and-tested strategy

Quality has long been a part of an active manager’s toolkit. In the passive investing space known as smart beta, however, the strategy is a relatively new addition to the factor mix.

This may be why compared to other factors ‘the dispersion in definitions is substantially largerfor quality,’ according to a 2016 study.3The paper’s authors found that definitions range from low levels of accruals, gross profitability and low investments to bottom-line profitability measures such as return-on-equity and margins.

Behind the iSTOXX Europe Quality Factor Index

The iSTOXX Europe Quality Factor Index assesses a company’s financial health through a combined approach based on profitability, leverage, and the consistency and reliability of reported earnings. The methodology takes five criteria into account:

  • Operating income to common equity
  • Cash to liabilities
  • Net external financing over total assets
  • Debt coverage
  • Earnings accruals quality

The index is one of six iSTOXX Europe Factor Indicesthat each tracks a well-researched source of systematic risk and returns. The index family also includes value, momentum, size, carry and low risk, and is completed by the iSTOXX® Europe Multi-Factor Index, which offers balanced exposure to all factors.

The iSTOXX Europe Quality Factoraims to extract the risk premium on quality while keeping unintended risks in check.It does so by imposing rules – common to all iSTOXX Factor Indices – that help manage illiquidity and high transaction costs, while preserving exposure to the factor. It also ties industry weights to the benchmark to prevent individual sectors from dominating the index.

What about tomorrow’s quality stocks?

As all factor strategies, quality is not a silver bullet. The strategy’s focus on strong company books may cause young and growing companies to be underrepresented as they may not yet be highly profitable.

Companies that are expanding their business may also fall by the wayside, as more aggressive investment behavior may lead to less favorable leverage ratios. Thus, quality portfolios may skew toward large caps,4missing out on returns generated by innovative ‘growth’ companies.

To counter these biases, investors may consider combining quality with a size strategy or going for a multi-factor approach. Thematic indices also present another option to tap into the performance of companies involved in promising innovative sectors, such as artificial intelligence or robotics. As always, a well-balanced approach is key.

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1Buffett, W., Letter to the Shareholders of Berkshire Hathaway Inc., March 1990.
2Total returns in euros after taxes.
3Kyosev, G., Hanauer, M., Huij, J. and Lansdorp, S., ‘Does Earnings Growth Drive the Quality Premium?’ Jun. 2016.
4Mariathasan, J., ‘Small caps: The smaller company effect,‘ I&PE, April 2018.