Quality defined

Quality investing encompasses several considerations, much to do with the financial characteristics of a company.

Commonly accepted attributes of a ‘quality’ company include its profitability, earnings reliability, debt levels and balance sheet strength. These characteristics are not plucked out of the air; rather, they have been empirically researched, tested, finessed and retested since the 1930s.

Identifying quality companies has been a focus of investors for a long time. Benjamin Graham wrote about it in Security Analysis way back in 1934. He followed up that with The Intelligent Investor, where he outlined what has become the basis for ‘the quality factor’. Graham said investors should demand from a company “a sufficiently strong financial position and the potential that its earnings will at least be maintained over the years.” Such companies, he claimed, show resilience by falling less in a downturn and recovering to previous highs quicker than other companies. 

These tenets, strong financial position and dependable earnings have been used to identify quality companies since then, and researchers have tested their efficacy and refined quality to help investors understand the quality factor and improve investor outcomes.

In the academic world, Friend and Lang (1987) included a “quality ranking” in their analysis of the size effect (the size effect is the observable long-term outperformance of smaller-sized companies over larger-sized companies). This was likely the earliest reference to quality as a standalone systematic factor in academic literature.

Over the next three decades, many more professors, researchers and industry participants undertook research to define quality, understand why it behaved the way it did, and to help identify the characteristics of quality companies.

After considering the academic and commercial research, MSCI’s review of the quality factor found that a company’s quality can be evaluated along five key dimensions: profitability, earnings quality, financial leverage, asset growth and corporate governance. 

The table below summarises how these dimensions can be measured.

Table 1: Measurable metrics for assessing quality

Source: MSCI

Asset growth and corporate governance tend to be difficult to quantify. On the other hand, profitability, earnings quality and financial leverage are readily available in financial statements. Therefore, by analysing the data in financial statements, these dimensions of quality can be used to construct theoretical, transparent, rules-based indices. Indices are MSCI’s bread and butter.

To work out how to best construct an index that captures the quality factor and understand how these metrics perform, MSCI created 10 portfolios with varying exposures to these dimensions and analysed the outcomes.

It was found that the portfolios that considered these metrics individually achieved a positive return against the MSCI World Index. However, combining all three equally provided superior performance to the standalone portfolios or different combinations of the metrics. From this, MSCI had the foundation for its MSCI World Quality Index.

VanEck’s popular international ETF tracks the MSCI World ex Australia Quality Index. Other index issuers also calculate quality indices, but the characteristics they consider, or the metrics they use, may be different to the ones MSCI utilise.

For example, Morningstar only consider two characteristics, ROE and low debt to equity, ignoring any earnings metric. Meanwhile, S&P utilises ROE, low debt-to-equity and an accruals ratio to assess a company’s earnings. All of these indices use equal weighting across the selected metrics.

These differences will result in different investment outcomes. Differences will be further skewed if, rather than equal weighting, greater emphasis is placed on a particular quality characteristic. The research is unequivocal in its support of equal weighting factors.

What’s an investor to do?

With so many definitions of quality, the difficulty for investors is identifying those funds that are truly “quality”. Unfortunately, it involves some homework.

It’s important to look under the bonnet of your ETF by looking at the description of the index the ETF tracks, which should be readily available. You can also look at the holdings and sector allocation. If you know a company has recently taken on debt to fund a new business or an acquisition, but it appears in the quality portfolio, it could be a red flag. Likewise, banks, a sub-sector with companies with a business model predicated on leverage, should not be a significant part of a true quality portfolio.

Of course, there is also a mathematical way to assess quality, using past returns and correlations — but we’ll save that for another Vector Insights.

Quality truly is in the eye of the beholder.