What’s a quality stock?

As an equity strategist, I constantly talk about investing in quality stocks but time and again, I notice that people mean something different when they talk about quality than what I mean when I talk about quality.

When I use the term “quality”, I use it in the way it is commonly used in the factor investing and smart beta world. Quality stocks are stocks with high profitability, whether that profitability is measured as Return on Equity (my preferred measure), Return on Assets, Return on Invested Capital, or whatever profitability you may want to use.

But my colleagues who are analysing individual stocks, as well as many fund managers, use the term “quality” more in the sense of “quality earnings”, i.e. a company with reliable earnings that doesn’t use too many accounting gimmicks like accruals and has few if any extraordinary cost items on its income statements.

Other definitions of quality one may see from time to time are quality in the sense of low financial leverage or “safety” and quality in the sense of high investments by the management relative to sales (indicating that the management is investing in future growth).

The good people at Amundi Asset Management looked at these four definitions of quality for global equities in order to find out which definition of quality is the best one. First, they did the usual exercise of grouping all stocks into five quintiles containing 20% of all stocks each. Then they looked at the performance of these quintiles from 2007 to 2020 to see if there is a declining trend from highest quality stocks to lowest quality stocks.

Performance of different quality measures 2007 to 2020

Source: Amundi Asset Management

The chart shows that profitability is the best measure in the sense that is best able to differentiate between high and low quality stocks in such a way that high quality stocks outperform low quality stocks. Earnings quality and investment intensity, on the other hand, have a really mixed track record with the stocks in the second lowest quality bucket (Q4) performing almost as good as stocks in the highest quality bucket (Q1). Safety, in the sense of low financial leverage, is better than earnings quality but worse than profitability.

When it comes to quality, the best measure to use seems to be profitability. But not so fast. The efficacy of factors changes and so does the performance of different proxies. The chart above shows the performance between 2007 and 2020 in the low yield environment of the post-GFC world. If we go back to the years before the financial crisis, the performance of the different quality metrics was very different. The table below shows the average annual outperformance of the highest quality bucket (Q1) in the Eurozone and Europe ex EMU (i.e. mostly the UK). The performance of each individual metric was vastly different before the GFC than after. Earnings quality, for example, did really well before the financial crisis and has an abysmal track record since. Profitability, meanwhile, was doing great over the last 15 years or so but has not worked at all in the years before the financial crisis.

What does create some stability over time, however, seems to be a combination of all four approaches to measuring quality. That approach has created decent outperformance across most regions before and after the financial crisis. In the end, quality seems to be a qualitatively different beast from most other factors insofar as it is much harder to describe by a single metric than for example value or price momentum.

Annual outperformance of highest quality stocks by different metrics

Source: Amundi Asset Management