This In Practice piece gives a practitioner’s perspective on the article “What Is Quality,” by Jason Hsu, Vitali Kalesnik, and Engin Kose, published in the Second Quarter 2019 issue of the Financial Analysts Journal.
What's the Investment Issue?
In investment, the term “quality” has long been shorthand for company characteristics that are believed to be predictors of business success and a rising stock price.
Quality is so well recognized as an indicator of corporate success that it has become a widely used factor similar to value and size. The world’s leading index providers have created fundamental beta indexes based on quality, and investment firms pitch quality as a source of both return and diversification.
Across the fund spectrum, investment firms adopt vastly different definitions of quality and use contrasting methods to incorporate quality into their products. There is no accepted industry definition of quality, and unlike the value and size factors, for example, the quality factor has multiple components. The authors investigate which of these components are genuine signals of the quality factor and which have been data-mined by funds and are effectively masquerading as signals.
By establishing which components of the quality factor truly drive returns, the authors reason, investors can better distinguish quality-designated portfolios.
How Do the Authors Tackle the Issue?
The authors identify the main components of quality used by investment firms across the globe:
• profitability—for example, gross profits and return on investment
• earnings stability—earnings volatility over time
• capital structure—the relationship between leverage and equity returns
• profitability growth—the relationship between investor returns and earnings
• accounting quality—governance related to reporting of corporate metrics
• payout/dilution—share issuance, dividends, buybacks
• investment—spending behavior (i.e., how conservative companies are in their spending)
These components represent a collection of signals that are often bundled together in what is best described as multi-factor or multi-signal portfolios. The authors aim to break down this aggregated approach by assessing the correlations between the signals to determine whether there is a common thread that leads to outperformance.
Previous research has focused on signals with strong backtests, resulting in multi-signal portfolios that deliver higher theoretical returns than are realistic for commercial funds, which tend to be based on an unsorted collection of heterogeneous signals. To reduce the risk of this kind of data mining, the authors use a three-step procedure to test the validity of each signal as a component of quality.
First, they assess whether a signal had been analysed in depth in a significant number of peer-reviewed papers and published finance literature. Second, they seek to establish whether a signal’s statistical significance is robust across long time periods and across geographic sectors—the United States, global developed markets, Japan, Europe, and Asia Pacific excluding Japan. Third, they assess whether a signal is still strong when there are multiple definitions of it. For instance, when analyzing the profitability signal, the authors measure return on equity (RoE) and return on assets (RoA), as well as more traditional definitions.
What Are the Findings?
The three-step process reveals that profitability, accounting quality, payout/dilution, and investment are genuine predictors of higher returns in quality portfolios. Within this outperforming group, profitability and investment-related signals capture most of the quality-related premiums.
Capital structure, earnings stability, and growth in profitability are not found to be indicators of excess returns.
In their review of the existing literature, the authors conclude that there is a large and meaningful volume of research on profitability and sufficient research on accounting quality, payout/dilution, and investment to be confident about the positive contributions of these signals to the quality factor. But there is relatively scarce research into the other signals, which the authors take as a lack of reliable evidence for those components.
Profitability offers outperformance on both a risk-adjusted and multi-factor basis. In their review of the literature, the authors find that the large body of research on profitability signals conform to the classic theoretical explanation that higher profitability must imply greater risk and a higher cost of capital. The profitability signal leads to high returns in global developed markets and Europe but not elsewhere.
Investment outperforms as measured by return spread and the Sharpe ratio but does not perform so well when measured by multi-signal alpha. The authors find strong academic evidence that companies that invest prudently produce better returns. The investment signal is significant in all regions except Japan, with a few exceptions.
Accounting quality delivers outperformance because, according to the authors’ review of the academic evidence, most investors focus on headline earnings and pay insufficient attention to signs of earnings manipulation. The authors find that accounting quality signals are significant in the United States, global developed markets, and Europe, but are not found in Asia Pacific excluding Japan.
There is considerable academic evidence that payouts (dividends plus repurchases) and net payouts (dividends plus repurchases minus equity issuance) are indicators of higher stock returns. At the same time, most types of share issuance lead to stock price underperformance. The authors find that payout and dilution signals are significant contributors to the quality factor in all regions studied except Japan.
What Are the Implications for Investors and Investment Professionals?
The biggest takeaway for investors is that profitability, accounting quality, payout/dilution, and investment all seem to be reliable sources of outperformance, but these signals are underappreciated by markets. The main exception to this finding is Japan, where none of the quality signals predicts excess returns.
The findings have particular interest for environmental, social, and governance (ESG) investors given that the strongest signals have a governance angle. The combination of strong profitability with prudent investment, for instance, can be seen as a sign of strong corporate governance. Companies with both these characteristics are unlikely to implement unrealistic growth targets as a result of managerial hubris or a misalignment of incentives. High accounting quality, however, can be seen as indicative of a culture of strong compliance, transparency, and integrity in company operations and reporting. Meanwhile, low dilution can be viewed as behavior worthy of the trust of shareholders.
The authors also suggest caution regarding some of the existing quality-based funds. Many funds treat the components of quality equally, but the authors find that some signals, such as profitability and investment in combination with accounting quality and payout/dilution, are considerably more valuable than others. Current marketing of some funds would suggest, for example, that it is possible to invest in high-growth and high-profitability companies that also have low levels of debt and prudent investment strategies. Most economists would argue that companies with this happy combination of attributes simply do not exist.