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A Closer Look at Quality: The Fuzziest of Factors

Buying good companies is a sensible strategy—assuming the price is right.

Ben Johnson 21.02.2019

Quality may be the fuzziest factor you will find in the investing world. There is no one agreed-upon definition for it, nor is there clear consensus that it is a true stand-alone factor. What's more, it is missing the risk story, the basic economic intuition, and the readily discernible behavioral underpinnings that explain the existence and persistence of the value factor. Here, I'll address what quality is and why it may or may not yield superior risk-adjusted returns.

The What
What is quality? The answer to this question will vary depending on who you ask. Common criteria that asset managers and index providers use to define quality stocks include measures of profitability (such as gross margins, return on equity, return on invested capital), stability (for example, earnings variability), growth (such as earnings growth or dividend growth), and financial health (for example, debt/equity ratios). Generally speaking, high-quality firms are consistently profitable, growing, and have solid balance sheets.

In their 2013 paper "Quality Minus Junk,"[1] AQR's Cliff Asness, Andrea Frazzini, and Lasse Pedersen demonstrated that stocks meeting many of the criteria described above, and thus fitting the high-quality mold, produced significant risk-adjusted returns in the United States and 24 other global stock markets. The trio found that investors tend to pay premium prices for these high-quality firms. That said, they are not quite sure how to explain the returns to quality:

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About Author

Ben Johnson  Ben Johnson, CFA is the Director of Passive Fund Research with Morningstar.

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