Quality Investing

Quality investing or Quality Factor Investing is a relatively new way of selecting stocks. It is closely related to value investing. Quality investing, however, not only looks at the price of a stock, but also at the quality. In other words, quality investors try to buy ‘good’ companies, not just cheap companies. Some investors even combine both approach, in which case the strategy is referred to as “quality at a reasonable price”. The approach was first studied by Asness, Frazzini, and Pedersen in 2013.

What is Quality Investing?

Buying ‘good’ firms is, of course, a bit too vague to be tractable. What makes a high-quality firm? Quality in this case is defined as good company properties investors can be expected to pay a higher price for. High quality means that the firm has a high present value of future cash flows. Considering Gordon’s Growth model (a type of dividend discount model):

    $$\frac{V_t}{B_t} = \frac{E_t(NI_{t+1})/B_t \cdot E_t(D_{t+1})/E_t(NI_{t+1})}{k-g}$$

On the left, we have the intrinsic value of the company, divided by the book value. This normalizes the value of the company, such that we can compare the intrinsic value of different companies. The right-hand side of the equation is better understood if we first write it as follows:

    $$\frac{V_t}{B_t} = \frac{ \textrm{profitability} \cdot \textrm{payout ratio}}{\textrm{required return} - \textrm{growth rate}}$$

 

The right-hand side shows the main qualitiy characteristics used by Asness, Frazzini, and Pedersen. These traits generally justify a higher valuation multiple. In particular, it contains the following set of traits:

  • First, there is Profitability which is defined as the profits (or net income) per unit of book value, Et(NIt+1)/Bt.
  • Second, we have Payout. Payout is the  fraction of the profits that are paid out to shareholders in the form of dividends. Et(Dt+1)/Et(NIt+1).
  • g is the growth rate of profits
  • k is the discount rate at which cashflows are discounted.

The formula states that investors are willing to pay a higher price multiple when the stocks exhibit higher growth, higher profitability, higher safety (lower k) and a higher payout ratio. It is a kind of ‘quality of earnings ratio formula’. The quality investing approach will buy stocks with higher growth, profitability, safety and payout ratios and sell stocks with low growth, profitability, safety and payout ratios.

Summary

We discussed quality investing, which is similar to value investing in that it looks as companies’ characteristics. However, whereas value investors try to buy stocks in a cheap way, quality investors are willing to buy stocks at higher prices if the stocks have good quality.

Interestingly, quality and value are often combined to form a ‘Quality at Reasonable Price‘ (QARP) strategy. This is a very attractive strategy because the returns to a quant quality and quant value factor are fairly uncorrelated. Combining value and quality should therefore lead to higher risk-adjusted returns. One should therefore not think of both approaches as a quality vs value. Instead, it is worthwhile to combine them.

The above topic is related to the following set of topics:

  1. Passive Investing
  2. Justified PE
  3. Bird-in-hand Theory
  4. PEG Ratio
  5. Sin Stocks