Deep dive into Quality

Fund managers often like to say that they invest in high quality companies.

At first glance, it appears they are stating the obvious. Who would want to invest in anything other than a quality company? Quality can be a generic term meaning something that is great or valuable, but in investment circles it has a more specific meaning. For a company to be classified as quality, it has to meet certain criteria. Whilst there is no fixed definition as to what those criteria are, there is broad agreement as to the attributes of a quality company.

Developing the concept of Quality investing

Quality as an investing concept can be traced back to Benjamin Graham and his 1949 book The Intelligent Investor. The concept grew in popularity around the early 2000s following the bursting of the dot com bubble and other spectacular failures like Enron and WorldCom. 

Jeremy Grantham of asset management firm GMO is a strong proponent of quality investing. He focuses on the attributes of high return, stable return and low debt. These attributes of profitability, earnings stability and capital structure have become the basis of many quality investing strategies. (Novy-Marx, 2014)

A study by Frazzini, Kabiller and Pedersen (2012) found Warren Buffett’s focus on buying high quality stocks, largely explains the performance of the listed stock portfolio held by Berkshire Hathaway, Buffett’s primary investment vehicle. (Novy-Marx, 2014)

Stocks are selected as high or low quality based on an analysis of their financial statements which measure the performance of the business. Ratios are used in the majority of cases to allow comparison across companies.

As most of these measures are based on accounting definitions, there is the possibility that the figures could be manipulated. However this should only be an issue at the margin. The accounting quality attribute, described below, attempts to overcome this.

When looking broadly at the concept of a quality company it can be thought of in a number of different dimensions:

• Is it a good company (quality of the franchise)

• Is it an improving company (Fundamental momentum)
• Is it a safe company (Bankruptcy & earnings risk)

The quality of the franchise is looking at whether the business is strong and stable. It looks at measures like profitability, cash generation, stability and growth of revenue, earnings and margins. Benjamin Graham is best known as the father of Value investing, but he was also just as concerned with a firm’s quality. He advocated buying quality businesses at a reasonable price, not just cheap stocks. He looked at balance sheet strength as well as earnings stability and growth. (Novy-Marx, 2014)

Fundamental momentum asks are the fundamentals (profit and loss, balance sheet and cash flow items) improving over time? A popular summary statistic used to measure this is the Piotroski F-score which looks at the movement across profitability, liquidity, and efficiency.

Quality in terms of safety is looking at the risk of bankruptcy or the risk that earnings will decline. Looking at capital structure and accounting quality can help predict this. When looking at the risk of bankruptcy, the Altman Z-score is a well established measure.

One way to assess the risk of earnings manipulation is to look at the Beneish M-score. The M-score is a model that uses eight financial ratios to try and identify if a company has managed or manipulated its earnings. The study used to build the model found the probability of earnings manipulation was correlated with:

• Unusual increases in receivables
• Deteriorating gross margins
• Decreasing asset quality
• Sales growth
• Increasing accruals

Using this model, Beneish was able to correctly identify 76% of known manipulators and only incorrectly identified 17.5% of non-manipulators. (Beneish, 1999)

Quality minus junk

In a 2017 paper by Clifford Asness, Andrea Frazzini, and Lasse Heje Pedersen titled “Quality Minus Junk”, the authors defined quality stocks as those that are safe, profitable, growing and well managed. They believed that all else being equal, an investor should be willing to pay a higher price for stocks with these attributes.

In the paper by Asness et al (2017), the authors constructed a quality minus junk factor strategy by taking long positions in high quality stocks and short positions in low quality stocks. They found that this strategy produced significant risk-adjusted returns in the US as well as across 24 other countries. Whilst high quality stocks were priced at a premium, that premium was not very high and did not eliminate the opportunity for superior returns. They also found that this premium, the price of quality, varies over time. For example it was particularly low during the dot.com bubble of the early 2000’s, setting quality stocks up for a period of outperformance.

This outcome was consistent with the hypothesis that market prices do not fully reflect the quality characteristics of a stock due to behavioural finance or constraints. In summary, they found strong and consistent abnormal returns from quality due to markets pricing quality inefficiently. They also found that current quality predicts future quality. On average they continue to display these characteristic over the ensuing five or ten years. (Asness, 2017)

Profitability

Profitability is probably the most common characteristic used to select stocks for quality portfolios. It has been widely studied with at least seven academic articles finding a positive premium associated with the characteristic. Hsu, Kalesnik & Kose (2019) looked at the robustness of the category across geographic regions. Looking at empirical evidence, they found that in the US, Europe and other developed markets, there was a statistically significant return advantage from profitability, especially on a risk-adjusted basis or a multifactor basis. (Hsu, 2019)

Novy-Marx found that “profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios.” (Novy-Marx, 2012) He measured profitability as gross profits (revenues less cost of goods sold) to assets. Whilst he found that other quality attributes did contribute to superior returns, gross profitability was by far the most significant contributor. This attribute forms part of Stockopedia’s Quality Rank and can be explored further here. (Novy-Marx, 2012)

Accounting quality

Accounting quality refers to the degree of certainty that the reported financials of a company reflect the actual underlying performance of the business. Cash flows ultimately reveal how a business is doing, whereas earnings as reported in the profit and loss statement will contain a range of adjustments from the cash flows for a variety of legitimate reasons. But sometimes managers may use these adjustments more aggressively in order to make the accounts look better than they otherwise would. For example, booking accrued sales revenue that may never translate into a cash flow.

A number of studies have looked at this issue and found that high accruals tend to result in lower returns. They attribute this to the tendency of market participants to look at headline earnings and either ignore, or be deceived by, manipulation of those earnings. This was confirmed by empirical evidence that found that accounting quality factors produced statistically significant returns, especially in the US and other global developed markets. (Hsu, 2019)

A study by Richard Sloan also found that stocks with high levels of accruals tend to experience negative future abnormal returns and vice-versa. He attributed this to a tendency on the part of investors to fixate on the earnings figure and fail to distinguish between the breakdown of earnings into cash flow and accruals. (Sloan, 1996)

Payout / Dilution

Payout refers to the amount of earnings paid out as dividends. This provides a positive return to shareholders. When companies issue shares the existing shareholders are often diluted, which is a negative return for shareholders. A buyback can be thought of as negative issuance and therefore is a positive for shareholders.

Boudoukh, Michaely, Richarson, and Roberts (2007) found that companies with higher payouts (dividends and buybacks) produce higher returns. Likewise net payout (dividends and buybacks less share issues) also predict higher stock returns. This holds true regardless of risk adjustments. (Hsu, 2019)

A number of studies have been conducted looking at the effect of share issuance on stock performance. They have all found a negative relationship, that is, the prevalence of share issues is likely to lead to under performance. (Hsu, 2019)

Quality - separating wheat from the chaff

In conclusion, at first glance, investing in quality appears to be a generic term about investing in good businesses. But as an investment strategy quality takes on a more precise meaning. There are numerous ways that a quality strategy can be constructed. They all include a profitability component, and indeed studies have shown that this component makes the biggest contribution to the performance of the strategy. Using Stockopedia’s Quality Rank is a good place to start when searching for high quality stocks.

References

Asness, Cliff S. and Frazzini, Andrea and Pedersen, Lasse Heje, 2017, “Quality Minus Junk”, 5 June, viewed 8 May 2022 at SSRN: https://ssrn.com/abstract=2312432

Beneish, M. 1999, “The Detection of Earnings Manipulation”, June, viewed 8 May 2022 from < https://www.scribd.com/doc/33484680/The-Detection-of-Earnings-Manipulation-Messod-D-Beneish >

Hsu, J., Kalensnik, V., Kose, E. 2019, “What is quality?”, Second Quarter 2019, Financial Analysts Journal

Novy-Marx, R. 2012, “The Other Side of Value: The Gross Profitability Premium”, June, Simon Business School University of Rochester, viewed 8 May 2022 from < http://rnm.simon.rochester.edu/research/OSoV.pdf >

Novy-Marx, R. 2014, “Quality Investing”, May, Simon Business School University of Rochester, viewed 9 May 2022 from < http://rnm.simon.rochester.edu/research/QDoVI.pdf >

Sloan, R. 1996, “Do stock prices fully reflect information in accruals and cash flows about future earnings?”, July, The Accounting Review, viewed 9 May 2022 from < https://www.wm.edu/offices/auxiliary/osher/course-info/classnotes/shanesloan1996tar1.pdf >

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