Does Quality Really Make A Difference?

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Includes: HDV, QUAL, SCHD, USMV, VIG
by: Investing Doc

Summary

Having used quality as a metric for selecting an ETF, I wanted to validate my assumption that quality makes a difference to risk-adjusted returns.

I performed a cohort trial using various time periods over the past 5 years, comparing the returns of high-quality companies versus the broader market.

I then re-ranked the 20 ETFs previously examined in my prior to articles and selected my favorites from the bunch.

In my last two articles, I ranked various dividend-focused, quality-focused, and low-volatility ETFs based upon various aspects, including historical total return, risk-adjusted returns, and current holding quality. Though the first two metrics are easy to grasp and subject to standardized calculation, it wasn't (and still isn't) possible to find a single, universally agreed-upon definition or formula for quality (though commercial products are out there).

So, I developed my own quality metric, developing a product involving average returns on equity, debt/equity ratios, and profitability. I assumed-reasonably, I think-that companies with steadier and greater returns on equity, lower amounts of debt, and higher degrees of profitability would tend to outperform their more unreliable, less profitable counterparts. (To this notion, I recently added on a metric for Economic Profit, or Return on Invested Capital in excess of a company's Weighted Average Cost of Capital - a feature often cited as being evidence for the presence of an economic moat. The updated rankings, which the inpatient reader may refer to below, include this.)

Unfortunately, my reasonable assumption is belied by some equally reasonable questions. If high-quality companies are so desirable to investors, wouldn't the market bid them up so high as to reduce the likelihood of underpricing? What explains the fact that unprofitable companies or more leveraged companies sometimes outperform their more high-quality counterparts? And does characterizing quality in such a quantitative way actually capture high-quality companies?

So I examined the correlation between fund holdings' quality and funds' risk-adjusted returns. The results were not encouraging:

The data weren't helped by the fact that the sample size is so small, but regardless, at first glance, any correlation between holding quality and total risk-adjusted return was a weak one, at best. A similar finding was found when correlating quality with fund dividend growth:

Again, a weak correlation at best. Had I erred in assuming that my quality metric was at all useful? What possible good would it do to look for quality if quality wasn't going to pay off? Troubled, I looked at the characteristics of the individual holdings themselves:

Here, the data are more reassuring. There appeared to be a positive, stronger correlation between quality and dividend growth, at least in terms of the ETFs' individual holdings. That is to say, the companies in funds with higher composite quality scores tended to have higher historical dividend growth rates than the companies with lower composite quality scores. But what if funds were screening for higher dividend growth and just happened to pick up companies that were higher quality? I decided that this correlation wasn't sufficient; what I needed was to see whether or not selecting a quality company now would lead to improved total return or dividend growth later.

So, I performed a cohort trial involving the 1000 or so stocks already examined, as well as the additional 250 or so comprising the remainder of the S&P 500 index (thus, some 1250 stocks in all). This trial simulated the results of a purchase of a stock at various points in time, selected based upon "high-quality" metrics at time of purchase:

  1. Highest percentile historical Return on Equity;
  2. Lowest percentile standard deviation of yearly ROE to date;
  3. Lowest percentile debt/equity ratio (at time of purchase); and
  4. Highest percentile Economic Profit (5-year median leading up to time of purchase).

For example, a screen run for such companies in the year 2010 might have generated a list like this:

Ticker

Company Name

Ticker

Company Name

Ticker

Company Name

Ticker

Company Name

MDT

MEDTRONIC PLC

SYY

SYSCO CORP

SLGN

SILGAN HOLDINGS

RL

RALPH LAUREN CORP.

UTX

UNITED TECH CORP.

PEG

PUBLIC SERVICE ENTERPRISE GROUP

MNRO

MONRO MUFFLER

AAP

ADVANCE AUTO PARTS INC.

NKE

NIKE INC.-CL B

HPQ

HP INC.

MLAB

MESA LABS

AET

AETNA INC.

TJX

TJX COS. INC.

OMC

OMNICOM GROUP

RBCAA

REPUBLIC BNCRP-.

AME

AMETEK INC.

GD

GENERAL DYNAMICS

GPC

GENUINE PARTS CORP.

MSFT

MICROSOFT CORP.

AMGN

AMGEN INC.

SYK

STRYKER CORP.

COH

COACH INC.

JNJ

JOHNSON & JOHNSON

APH

AMPHENOL CORP.

ITW

ILLINOIS TOOL WORKS

XLNX

XILINX INC.

T

AT&T INC.

BAX

BAXTER INTERNATIONAL INC.

BDX

BECTON, DICKINSON

DGX

QUEST DIAGNOSTICS

PG

PROCTER & GAMBLE

COL

ROCKWELL COLLINS INC.

ECL

ECOLAB INC.

MAT

MATTEL INC.

KO

COCA-COLA CO.

HD

HOME DEPOT INC.

PX

PRAXAIR INC.

MCHP

MICROCHIP TECH

PEP

PEPSICO INC.

HUM

HUMANA INC.

SPGI

S&P GLOBAL INC.

HAS

HASBRO INC.

INTC

INTEL CORP.

INTU

INTUIT INC.

SHW

SHERWIN-WILLIAMS

BBY

BEST BUY CO. INC.

CSCO

CISCO SYSTEMS

ORCL

ORACLE CORP.

ROST

ROSS STORES INC.

AJG

ARTHUR J.GALLAGHER

MCD

MCDONALD'S CORP.

STJ

ST JUDE MEDICAL INC.

BCR

CR BARD INC.

DRI

DARDEN RESTAURANTS

WMT

WAL-MART STORES

UNH

UNITEDHEALTH GROUP INC.

GWW

WW GRAINGER INC

JWN

NORDSTROM INC.

MMM

3M CO.

DD

DUPONT (EI)

PRGO

PERRIGO CO. PLC

GPS

GAP INC./THE

TGT

TARGET CORP

INTC

INTEL CORP.

MKC

MCCORMICK-N/V

FLO

FLOWERS FOODS

KMB

KIMBERLY-CLARK

SPGI

S&P GLOBAL INC.

IFF

INTERNATIONAL FLAVORS & FRAGRANCES

FII

FEDERATED INV-B

D

DOMINION RES/VA

BF.B

BROWN-FORMAN CORP.

ALB

ALBEMARLE CORP.

BOH

BANK OF HAWAII

RAI

REYNOLDS AMERICA

FTI

FMC TECHNOLOGIES INC.

TIF

TIFFANY & CO.

TUP

TUPPERWARE BRANDS

ADP

AUTOMATIC DATA

MTD

METTLER TOLEDO INC.

JKHY

JACK HENRY

LXK

LEXMARK INTL-A

RTN

RAYTHEON CO.

VAR

VARIAN MEDICAL SYSTEMS INC.

TTC

TORO CO.

WDR

WADDELL & REED

GIS

GENERAL MILLS

BCPC

BALCHEM CORP.

DCI

DONALDSON CO. INC.

GES

GUESS? INC.

EMR

EMERSON ELECTRIC CO.

WDFC

WD-40 CO.

OZRK

BANK OF THE OZARKS

GEF

GREIF INC.-CL A

EXC

EXELON CORP

ASEI

AMERICAN SCIENCE & ENGINEERING

ITT

ITT INC.

CHE

CHEMED CORP.

APD

AIR PRODS & CHEMICALS

GTY

GETTY REALTY CORP.

AFL

AFLAC INC.

CSX

CSX CORP.

SRCL

STERICYCLE INC.

DLTR

DOLLAR TREE INC.

LH

LABORATORY CORPORATION OF AMERICA

Click to enlarge

This list is riddled with well-known entities, such as stalwarts 3M, Dividend Aristocrats like Wal-Mart, and other favorites like TJX Companies and Microsoft. As a group, the stocks in this portfolio all had (as expected) lower debt/equity ratios, higher returns on equity, and steadier earnings histories:

Let's say an investor had done their research, found these stocks on their screener, and purchased them at some point in 2011, without regard to valuation. How would they have done?

The answer, as it turns out, is pretty darned well:

True, quality hasn't always outperformed, though over the past few years, it has done a decent job keeping up. As the bull market has aged in recent years, however, high-quality stocks have kept climbing, whereas the rest of the market has lagged behind. What if you stripped out the higher-quality companies from the equation? How would a "low-quality" portfolio have performed?

As it turns out, if you had purchased the "low-quality" portfolio, you would've done okay, but with significantly higher volatility. The outperformance of the portfolio - which was much larger than its high-quality counterpart - might be explained by the presence of a few of outstanding members, like Google (NASDAQ:GOOG), Amazon (NASDAQ:AMZN), and Boeing (NYSE:BA), all of which have done pretty well over the past few years. Some of these low-quality names might even have morphed into "high-quality" companies - having reduced debt ratios, expanded profit margins, and steadied earnings growth.

But the takeaway here seems to be that total returns were higher than for a portfolio of uniformly "higher-quality" stocks than for a portfolio of "lower-quality" ones, with less volatility to boot. This seems to be true for whether or not you started with stocks in 2010, 2011, or 2012, and whether or not you held those stocks for 3-, 4-, or 5-year periods:

Moreover, the positive effect of higher-quality portfolios was better seen when volatility and higher risks were taken into account:

So over the past 5 years, portfolios of quality stocks - stocks of companies with lower amounts of debt, consistent histories of uninterrupted profitability, and excess economic profits - have offered superior risk-adjusted returns in comparison to lower-quality cohorts, regardless of holding period or time of purchase. Though the sample here does not include a real prolonged bear market, such as the 2008 financial crisis, the data do suggest that there might be something to buying quality stocks for excess risk-adjusted returns.

Of course, there is a caveat: just because quality stocks have generated excellent returns over the past 5 years doesn't guarantee they'll do so in the future. With the broader market being bid up to ever-higher levels, stocks of all types have seem some degree of multiple expansion, with quality stocks trading at the highest prices:

Furthermore, whereas stocks in general are pretty much fully valued (running at about 95% of analysts' consensus targets), quality stocks (as currently screened) trade at a not-insignificant 140 basis point premium. Much of this has to do with the flight to quality that started in 2014 and accelerated earlier this year. Quality stocks also have significantly higher expectations built into their targets, with 5-year expected growth rates about 250 basis points higher (7.4% versus 4.8%). While this probably an expected finding, it does suggest a higher hurdle to clear for quality stocks now that prices basically bake in analysts' growth expectations. At first glance, it would seem that the risk-reward ratio for quality stocks looks less favorable at the moment than it has been in the past, and that potential investors ought to be demanding when it comes to valuation. A list of quality companies currently trading below analyst consensus estimates follows:

Ticker

Company

Price

Target

Price/Target

WAB

WABTEC CORP.

$70.72

$97.80

0.723

ALK

ALASKA AIR GROUP INC.

$64.71

$82.88

0.781

AAPL

APPLE INC.

$98.67

$124.73

0.791

CBG

CBRE GROUP INC.

$28.99

$36.25

0.800

FL

FOOT LOCKER INC.

$58.53

$71.88

0.814

LAD

LITHIA MOTORS INC.

$83.28

$101.14

0.823

COL

ROCKWELL COLLINS INC.

$85.17

$98.92

0.861

NKE

NIKE INC.-CL B

$57.76

$65.70

0.879

PII

POLARIS INDUSTRIES

$95.03

$106.53

0.892

JBHT

HUNT (JB) TRANS

$81.55

$89.92

0.907

PII

POLARIS INDUSTRIES INC. COMMON

$96.53

$106.40

0.907

EL

ESTEE LAUDER COS. INC/THE

$93.16

$102.33

0.910

AMGN

AMGEN INC.

$166.00

$182.23

0.911

TSCO

TRACTOR SUPPLY CO.

$91.74

$99.74

0.920

HON

HONEYWELL INTERNATIONAL INC.

$115.88

$125.58

0.923

FAST

FASTENAL CO.

$41.90

$45.29

0.925

MMS

MAXIMUS Inc.

$59.56

$64.33

0.926

HAS

HASBRO INC.

$80.65

$86.56

0.932

VFC

V.F. CORP.

$64.22

$68.72

0.935

CBRL

CRACKER BARREL

$156.52

$164.80

0.950

CHRW

C.H. ROBINSON

$71.24

$74.93

0.951

NEU

NEWMARKET CORP.

$420.06

$440.00

0.955

TJX

TJX COS. INC.

$79.67

$83.06

0.959

APH

AMPHENOL CORP.

$58.92

$61.40

0.960

KO

COCA-COLA CO.

$45.51

$47.42

0.960

SMG

SCOTTS MIRACLE-GRO CO.

$73.49

$76.33

0.963

RTN

RAYTHEON CO.

$136.70

$141.92

0.963

M

MACY'S INC.

$35.28

$36.10

0.977

GWW

W.W. GRAINGER INC.

$217.05

$221.20

0.981

UTX

UNITED TECH CORP.

$106.04

$107.82

0.983

XLNX

XILINX INC.

$47.84

$48.47

0.987

VAR

VARIAN MEDICAL SYSTEMS INC.

$87.04

$87.80

0.991

BBBY

BED BATH AND BEYOND INC.

$44.49

$44.85

0.992

DOV

DOVER CORP.

$73.05

$73.18

0.998

MMM

3M CO.

$181.24

$181.17

1.000

Click to enlarge

Interesting companies from this screen include the CBRE Group, which had recently taken a hit after Brexit, though it has since regained some ground. Amgen (NASDAQ:AMGN) looks compelling as well, as biotech continues to be unloved - the company's competitive position looks defensible, and its valuation doesn't look too demanding.

Thus, the data do suggest that higher-quality companies can help generate improved risk-adjusted total returns, and that screening for quality in ETFs isn't a fruitless exercise - though valuation still matters. Armed with this knowledge, I turned back to my ETF rankings to see which of them I'd be willing to buy right now:

Rank

ETF

Valuation

Yield

Quality

1

HDV

-0.366

3.40%

1.76

2

QUAL

-0.073

1.84%

3.84

3

SCHD

-0.214

2.86%

3.00

4

USMV

-0.326

1.97%

8.29

5

VIG

-0.161

2.13%

12.04

6

SPLV

-0.274

2.00%

6.17

7

SDY

-0.227

2.33%

4.05

8

SDOG

-0.059

3.31%

0.71

9

VYM

-0.143

3.06%

0.43

10

SCHV

-0.303

2.64%

0.85

11

NOBL

-0.186

1.82%

6.11

12

SPHD

-0.140

3.32%

0.26

13

DLN

-0.184

2.65%

1.85

14

DGRW

-0.096

2.13%

6.38

15

DVY

-0.344

3.11%

0.41

16

DON

-0.224

2.32%

1.86

17

DGRO

-0.139

2.35%

3.64

18

PEY

-0.318

3.17%

0.83

19

DIV

-0.322

7.42%

-0.92

20

DHS

-0.339

3.11%

-0.38

Click to enlarge

Of the top-5 scoring ETFs in this analysis, HDV looks appealing in terms of its current yield, but falls a bit short on quality, and its valuation is a bit rich at the moment. Despite its appearance at the top of the rankings, it falls to my "save now and buy later" pile; the same goes for USMV. QUAL's valuation is the cheapest in the entire bunch, which makes it very appealing, which belies its low yield, and its quality score was highly decent. VIG falls somewhere in the middle when it comes to valuation, but competes decently on yield, and its quality score was the highest in the group. SCHD seems to fall somewhere in the middle of the pack.

Conclusion

Over the past 5 years, quality - as defined by low debt ratios, earnings steadiness, and high degrees of profitability - really has been an important driver of excess risk-adjusted total returns, and portfolios that have focused on quality probably reaped significant benefits. The data suggest that quality is an important factor in dividend increases and sustainability, making it a higher priority for dividend-focused investors. Including a screen for quality when looking for a dividend-focused or other income-generating ETF can be a useful way to identify ETFs capable of generating excess total returns down the road. However, in the current environment, where quality has significantly outperformed over the past couple years, valuation matters as well. As for me, while I'll continue to hold my position in SCHD, I may initiate a position in QUAL, particularly if this rally takes a breather.

Disclosure: I am/we are long SCHD, AMGN, CBG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.