Aurora Borealis
1 January 2014 CFA Institute Journal Review

Quality Minus Junk (Digest Summary)

  1. Mohammed Saqib

Studying the price and return behavior of quality stocks, which are defined as those with high profits, high growth, low risk, and high payouts, the authors determine that the price premium commanded by these quality stocks is lower than that of other stocks. As a result, quality stocks yield above-average risk-adjusted returns compared with junk stocks. Moreover, the price premium of such quality stocks declines further before crises, such as before the dot-com bubble and 2008 crisis.

What’s Inside?

The authors identify a very interesting puzzle that defies asset pricing theory and accepted behavioral economics. It is an established notion that required returns are a function of risk—the higher the risk, the higher the required return should be. The authors study the returns on quality stocks over time. Quality stocks are defined as stocks that have high profitability, high growth, low risk, and high payouts. Logically, the prices of such stocks should demand a premium over other stocks and thus should yield lower returns on a long-term basis. But they find that the price premium being paid by investors for quality stocks is not sufficient, which results in higher risk-adjusted returns on quality stock and negative risk-adjusted returns on junk stocks.

How Is This Research Useful to Practitioners?

The authors demonstrate that quality securities segregated on the basis of an extension of the Gordon growth model (i.e., profits, growth, low risk, and payout) do not command enough of a price premium. The pricing premium is slightly positive for stocks with high profit and growth, positive to neutral for low-beta stocks, and negative for stocks with high payout. Although the combined pricing premium of these four quality factors is positive, it is not high enough. The end result is high risk-adjusted returns from such stocks on a consistent basis. The authors argue either that this price anomaly and the consequent return anomaly negate the efficient market hypothesis or that the definition of quality stocks, as determined by investors, has other criteria than the four defined by the authors. This low-pricing premium is further reduced before major market upheavals.

A major implication of the findings is that investors probably have assumed that high-quality stocks are efficiently priced, which results in a bias toward betting on junk stocks because of their perceived low price. Quality stocks based on the authors’ proposed four criteria not only yield higher returns but also provide a safety net during crises because, historically, such stocks have commanded a higher premium as a result of a flight to quality after a crisis.

How Did the Authors Conduct This Research?

The authors take a sample of about 40,000 stocks from June 1951 to December 2012 covering 24 countries. Several portfolios in each market are analyzed by forming a quality minus junk (QMJ) portfolio with each one being long the top 30% of quality stocks and short the bottom 30% of junk stocks. They then analyze the returns from these portfolios. Quality stocks are defined as stocks that meet the following four criteria:

  • Profitability, which includes such measures as gross profits over assets, return on equity, return on assets, and cash flows over assets.
  • Growth, which is defined as stocks that exhibit high growth on the above-mentioned profitability criteria.
  • Risk, which includes stocks with low market beta, volatility, and leverage.
  • Payout, which includes stocks with higher payouts through dividends and/or buybacks.

The QMJ portfolio delivers above-average returns in 23 out of the 24 countries that were analyzed. The authors also confirm that the price of quality stocks is low before a major crisis.

Abstractor’s Viewpoint

Very interesting inferences can be drawn from the findings of this article. Consistent above-average returns on the QMJ strategy portfolio could be because of the following factors:

  • Quality stocks were probably not assumed to maintain the same performance based on past results. Although the authors argue that quality stocks are able to maintain their quality benchmark over 5-year and 10-year horizons, this analysis is historical. It is possible that lower premiums were the result of overall doubts about the sustainability of profits, growth, and other criteria of quality stocks, which resulted in lower price premiums. This area needs to be investigated further.
  • The findings of the study indicate that investors accepted the fallacy of not following the herd mentality, which resulted in too many investors making bets on junk stocks.

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