Quality and Profitability Factors

The quality factor captures the tendency of high quality companies, those that are profitable, stable, growing steadily and conservatively financed, to deliver better risk adjusted returns than low quality companies. Unlike value, which focuses on price, quality focuses on the business itself. Quality has been one of the more consistent factors in recent decades and tends to hold up well during market downturns, making it popular with both quantitative and fundamental investors.

How quality is measured#

There is no single definition. Common components:

The evidence#

• Robert Novy Marx (2013) found that gross profitability (gross profit divided by assets) predicted returns as strongly as book to market, and that profitable firms outperformed unprofitable ones.
• Fama and French (2015) added a profitability factor (RMW, robust minus weak) and an investment factor to their five factor model.
• Asness, Frazzini and Pedersen (2019), in "Quality Minus Junk", built a broad quality measure and found that high quality stocks earned higher risk adjusted returns across many countries.

Why might quality work?#

Quality and value: a strong pair#

Cheap stocks are often cheap because they are low quality; expensive stocks are often high quality. Combining the two, "quality at a reasonable price", helps avoid value traps and overpriced quality. Benjamin Graham and Warren Buffett both emphasised buying good businesses at sensible prices. Quantitative research has found that value and quality combine well because they are negatively correlated. See Value Factor and Combining Signals.

Quality and low volatility#

High quality stocks tend to be less volatile, so the quality and low volatility factors overlap. Some research argues part of the low volatility effect is explained by profitability. See Low Volatility and Defensive Factors.

Risks#

• Valuation: quality stocks can become expensive when popular.
• Definition sensitivity: results vary with the measures used.
• Speculative rallies where junk outperforms.
• Crowding in popular quality ETFs. See Factor Timing, Crowding and Crashes.

Building a simple quality score#

A practical quality score might average the cross sectional ranks of gross profitability, return on equity, low leverage and low accruals. Stocks in the top third form the quality portfolio. Using several measures reduces dependence on any one accounting figure and makes the score harder to game. See Combining Signals.

Frequently asked questions#

What is the quality factor?#

A factor that favours companies with high profitability, stable earnings, strong balance sheets and good earnings quality.

Does the quality factor work in downturns?#

Historically it has tended to hold up well in market selloffs, as investors move toward financially strong companies.

Why combine quality with value?#

Because cheap stocks are often low quality, and combining the two helps avoid value traps while not overpaying for quality.

Next, learn about the small company effect in Size Factor.