Factor investing, otherwise known as smart beta, is an investment strategy that falls at the intersection between passive and active investment management. The strategy seeks to gain exposure to various systematic historical drivers of stock performance, called “factors.” Common factors include: value, momentum, size, volatility and quality. Many investors have heard of these factors, but not all investors have a deep understanding for exactly how each one works. This blog takes a closer look at one of the more complex factors: quality. As shown below, the Russell 1000 Quality Factor Total Return Index has outperformed the Russell 1000 Total Return Index by 5.6% percent year-to-date.1
What is the quality factor? Definitions for quality vary across the industry. Here at Deutsche Asset Management, in partnership with FTSE Russell, we define quality in terms of profitability and leverage. Accordingly, this factor seeks to identify stocks that exhibit persistent profitability and low leverage. Three metrics influence firm profitability and its persistence, namely: return on assets (ROA), changes in asset turnover, and accruals. On the other hand, a firm’s level of leverage is measured by using a ratio of operating cash flow to total debt. This blog takes a closer look at these metrics and how they pertain to determining a company’s quality.
Let’s begin with profitability. The term “profitability” is not the same as “profit”. Profit is an absolute number calculated as total revenue minus total expenses on the income statement. Whereas, profitability measures profit relative to the size of a business. In this sense, profitability measures the efficiency of a business in terms of how well it can produce a return on investment. Therefore, when seeking out a high quality company, the quality factor aims to identify firms that are profitable rather than those that simply have profits.
We are able to gauge a firm’s profitability by using the three aforementioned fundamental metrics. The first, ROA, is the most direct measure of profitability and it is calculated by dividing net income by total assets. ROA measures how well a firm deploys its underlying assets to produce earnings, and it assesses a firm’s overall level of profitability. All else equal, companies that exhibit higher ROA are considered more profitable than those with lower ROA. Historical data suggest that companies that exhibit current high levels of profitability also tend to exhibit future high levels of profitability (although this is not guaranteed). As such, the quality factor aims to overweight companies that exhibit high levels of ROA.
The second metric, change in asset turnover, is a way to understand not just profitability but improvements in profitability. Asset turnover measures a company’s sales relative to its asset base. In this sense, the ratio measures firm efficiency by indicating how many dollars of sales are generated per dollar of assets. Changes in this ratio provide insight into whether a company’s profitability is either strengthening or weakening. An increasing ratio suggests a company that is improving its efficiency, which should ultimately lead to improved profitability. Therefore, the quality factor seeks to overweight companies that exhibit improving asset turnover ratios.
The third metric, accruals, attempts to capture the historical and well-documented accruals anomaly, which is the negative relationship between accounting accruals and subsequent stock returns. This anomaly relates to the persistence of profitability. Academic evidence (see Sloan 19962) indicates that earnings attributable to accruals (such as accounts receivable) exhibit lower persistence than earnings attributable to cash received. Accruals are an accounting construct that allow companies to keep track of non-cash-based accounts such as accounts receivable. Since they are non-cash, accruals can also serve as a means for earnings manipulation because they are subject to a high level of manager discretion. In other words, misestimating accruals could decrease a company’s earnings quality. Therefore, to identify firms that report high quality earnings and to capture the seemingly persistent accruals anomaly, the quality factor underweights companies that exhibit higher levels of accruals.
Beyond profitability, the second component of the quality factor is leverage. Leverage is calculated by dividing operating cash flow by total debt. Historically, low levels of cash flow to debt have been shown to be related to the likelihood of business failure. Logically, companies that have higher leverage face a higher risk of default. In addition, historical data indicate that increased leverage is typically associated with lower future profitability. Accordingly, the quality factor tilts portfolios towards investing in companies that have lower levels of leverage.
Overall, the quality factor captures detailed information about companies and aims to enhance investor returns by tilting portfolios towards stocks that rank well from both a profitability and leverage standpoint. We seek out companies that earn more dollars of net income per dollar of assets, squeeze more sales from their assets this year than last, report high quality earnings, and use relatively less leverage. We hope that by digging deeper into how the quality factor works, this blog gives investors a better understanding of why they might choose a factor investing strategy that systematically seeks companies that score well on quality. More on factor investing can be found on our dedicated factor investing website: deutscheam.com.
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