Insight From Quant Research Part 1: Quality Minus Junk
Summary Renowned investors like Warren Buffett proclaim the attractiveness of “high quality” stocks. But what evidence is there that these really outperform across the board? Prominent researcher / hedge fund manager Cliff Asness investigated this question. Background Even for those that consider themselves purely bottoms-up, fundamental investors, there is a lot of valuable insight to be gleaned from the large volume of quantitative research available in the academic literature. One of the most noteworthy pieces over the past few years, “Quality Minus Junk” , is an emblematic example. This paper was written by Cliff Asness (one of the best known quantitative investors / hedge fund managers today), along with Andrea Frazzini and Lasse Pedersen from AQR Investments, and studies the tendency for “high quality” stocks to generate alpha relative to “low quality” stocks. In this article, I’ll walk through the key findings and why they’re valuable for us. Research Methodology In order to test the hypothesis about whether high-quality stocks do in fact outperform, Asness et al. first had to decide how to define “quality.” They ultimately decided to adopt a broad definition, by taking the average of four different proxies: Profitability : They measured profits (per unit of book value) in several ways, including gross profits, margins, earnings, accruals and cash flows. Growth : This was calculated over the period spanning from the prior five years in each of their profitability measures. Safety : They assessed both return-based measures of safety (e.g., market beta and volatility) and fundamental-based measures of safety (e.g., stocks with low leverage, low volatility of profitability, and low credit risk). Payout : The payout ratio is the fraction of profits paid out to shareholders, and can be seen as a measure of shareholder friendliness. The particular metrics they used were equity and debt net issuance and total net payout over profits. They then computed a quality score based on this definition for 39,308 stocks, covering 24 developed market countries between June 1951 and December 2012. Finally, for each of the U.S. and the global basket of developed market countries, they calculated the historical-return series resulting from buying the top 30% high-quality stocks and shorting the bottom 30%. Here is what these series look like. Key Findings As the visuals above would suggest, this ‘quality minus junk’, or QMJ, factor delivered positive returns in 23 out of 24 countries that they studied and highly statistically significant risk-adjusted returns both in the U.S. and abroad. This reflects the researchers’ observation that although higher-quality firms have exhibited higher prices on average, they have still been sufficiently undervalued relative to low-quality firms to deliver meaningful excess returns. Upon digging in deeper, there are also a couple of additional noteworthy findings from this analysis. Importantly, beyond looking just at the raw returns of their QMJ series, they also calculated its alpha by running regressions on the four standard Fama-French risk factors (market beta, small-minus-big, high-minus-low book value, and up-minus-down – i.e., momentum). The purpose was to demonstrate whether there is indeed statistically significant alpha beyond what can be explained by the standard risk factors. As shown below, they found that there was, with 0.5%+ of monthly alpha in most geographies. Finally, they evaluated QMJ’s alpha in different types of market environments, shown below. Interestingly, they found that the alpha was particularly strong during recessions, which they attribute to a “flight to quality” among investors during these periods of time. In other words, in addition to offering positive returns, QMJ could also reduce a portfolio’s market risk. This characteristic is particularly notable given that it seems to clearly contradict the critical underpinning of the efficient market hypothesis that investors can only be rewarded with excess returns for taking additional market risk. Conclusion Many renowned investors (most famously, Warren Buffett) have proclaimed the attractiveness of long-term investing in high-quality businesses, particularly when prices are relatively low. Investors can take more comfort in these assertions given that they are in fact backed up by a relatively large body of historical data from around the world.