To my experience one of the more popular strategies in stock investing is to find a quality company with a good price. Probably popularized by Warren Buffet and best summarized by the famous quote:
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
This is also what I try to find myself. But being a research minded person I started to wonder how much truth is there to this? Quality is very subjective and hard to measure. One could say that it is one of those things that you just know when you see. And therefore, there are far less evidence from returns of quality stocks than there are from value stocks, for example. After all, value premium has been captured internationally in many markets and with huge amounts of data, so it is hard to argue about the existence of a value premium. (Although one can very well argue if it's because of risk or not). But evidence from quality premium is scarcer, yet it still seems to be a very popular investment strategy. Here I will review a few studies made from quality, or maybe better described by profitability, to find out what are the best metrics for quality and if one can get alpha from quality strategies.
Robert Novy-Marx researched different kinds of measures for quality in his paper. He performs backtests to various different quality metrics, including Piotroski F-score, ROIC, Grantham's measures for quality, etc. Interestingly, the metric that performs the best in the backtests is Gross profitability. This is defined in the paper as: (Revenues - Cost of Goods sold)/total assets, so it is basically gross profit scaled by assets (Novy-Marx (2013)). The argument behind the metric is that it is the cleanest measure of profitability and other items further down on the income statement can distort true profitability. For example, R&D expenses can actually improve future potential, but high R&D spending would result as lower profitability when using net income, or EBIT.
The three factor alpha of the Gross profitability strategy (long-short) is 5.21%/year in the paper. This is the highest value, although Grantham's measure of quality also has a high alpha being 4.84%. When examining long-only strategies, Gross profitability is again the best performer having three factor alpha of 2.74%/year.
Moreover, it seems that quality and value strategies are great hedges to each other. Gross profitability and various other quality strategies examined in the paper have a large negative correlation with value strategies (low P/B). Quality strategies also doesn't have exposure towards small stocks like value strategies tends to have. Most metrics actually show negative coefficients for the Fama & French SMB-factor.
Based on these results by Novy-Marx, combining quality strategy and small cap deep value strategy would be a match made in heaven, resulting in significant alpha with not much additional risk. It is also interesting that Gross profitability is not correlated with defensive stocks, which are defined in the paper as low beta stocks. This seems to indicate that low beta is not a very good proxy for quality. I used to think that low beta and quality are a bit like two sides of the same coin.
Novy-Marx also combines profitability and value metrics. When stocks are selected based on both, value and quality, the returns are higher in all cases. However, also in this case the best performer is Gross profitability, especially among large caps. In small caps, the results are much more close to each other. Maybe the most notable observation here is that a strategy that selects stocks based on value and gross profitability is associated with significantly lower maximum drawdowns (-18.9% vs. value -43%). Investors could therefore avoid the deepest declines by including quality metrics to the investment process.
Quite surprisingly, to me at least, the best single metric to identifying quality seems to be Gross profitability, at least based on research by Novy-Marx. This metric leaves ROIC, F-score and other measures behind. And it also seems that Warren Buffet is right in his famous quote. Quality strategies can indeed generate significant risk adjusted alpha and the effect is boosted when combined with value (i.e. buying quality cheaply). Traditional value investors could benefit greatly from quality strategies, because quality is adversely correlated with value strategies. When value strategies plummet, quality usually does not, so the two should work greatly as hedges to each other.
Personally, I feel much more confident in hunting quality companies cheaply knowing that there are research confirming this old wisdom. And maybe I will start using Gross profitability as a screening metric.
Sources: Quality investing & The Other Side of Value: The Gross Profitability Premium, Journal of Financial Economics 108(1), 2013, 1-28.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.