The Quality Factor Takes Center Stage

Ask 10 asset managers how they would define quality and you would get 10 different definitions. Some believe it is the most misused term in investing.

Still, after equities suffered a sharp correction in the fourth quarter and rising corporate debt levels suddenly became a headline market concern, the quality factor is dominating investment conversations. “If we are going into a slowdown, the quality of balance sheets and the durability of earnings should float to the top,” says Mark Balasa, co-founder and chief investment officer at Balasa Dinverno & Foltz in Chicago.

Some sophisticated investors today are favoring the more granular lens of factor investing as providing more information than simplistic style-box analysis. Factors such as momentum, value, size, yield and quality increasingly are viewed as vehicles to construct more effective portfolios. Quality can be traced back to Benjamin Graham, but in today’s investment universe, there are two primary definitions of quality, according to Balasa. One developed by the University of Rochester’s Robert Novy-Marx simply takes free cash flow and divides it by total assets. The second, initially developed by Barra, combines return on equity, debt-to-equity ratios and earnings variability to create a metric. Today, many asset management firms have developed their own proprietary methodology to assign quality scores to individual stocks.

On its website, MSCI says that between 2002 and 2015, stocks with favorable quality readings “persistently outperformed” those with poorer scores. It adds that this performance gap was particularly pronounced during the 2008-2009 financial crisis and the subsequent recovery. Extensive research by quants at Northern Trust Asset Management supports this conclusion.

There are other reasons that quality is garnering so much airtime as 2019 begins. Until the fourth quarter correction began, many “low-quality names were priced for perfection” and got hammered, according to Mike Hunstad, head of quantitative research at Northern Trust Asset Management. Then as the correction accelerated toward bear-market territory in December, investors became scared and fled to high-quality companies.

Many managers try to go well beyond simply applying a group of financial yardsticks to screen for strong companies with predictable returns. Rajiv Jain, chairman and chief investment officer of GQG Partners, believes that it is imperative to embrace a “forward-looking” approach in the age of disruption.

Many businesses that once belonged to the quality universe no longer do. In the second half of the 20th century, companies like Philip Morris (now Altria) and Anheuser-Busch would have been poster children for the asset class, generating high levels of predictable earnings that were impervious to multiple recessions. But declining unit sales eventually overwhelmed Philip Morris’s huge profit margins and craft beers cut into Budweiser’s dominance.

Consumer staples businesses like PepsiCo and Coca-Cola are considered a key part of this asset class, but today’s market is weeding out many companies as millennial consumption preferences change. “Quality means downside protection,” Jain observes.

Jain adds that when one takes a backward-looking approach to quality, the benefits can quickly “be arbitraged away.” An increasingly democratized economy is making companies that were once impregnable suddenly vulnerable.