Quality Factor Work

The inherent inconsistency in the definition of ‘quality’ makes it difficult to gauge the true determinants of the

quality premium i.e. the higher excess returns exhibited by high quality companies vis-a-vis companies of low quality. Academics and practitioners, including index providers, generally evaluate a stock’s quality based on its financial and accounting/reporting quality.

Hsu, Kalesnik, and Kose (2019) (Hsu et al., 2019) examined the quality premium by comparing 7 different traits, namely profitability, earnings stability, capital structure, growth, accounting quality, payout/dilution, and investment. Based on their study, covering the US, Global Developed, Japan, Europe, and Asia Pacific ex-Japan over the period 1990-2016 (1963-2016 for the US), they concluded that quality metrics focusing on capital structure, earnings stability and growth had little impact on the quality premia. On the contrary, profitability, accounting quality, payout/dilution, and investments (capital expenditures) tend to drive the quality premium.

In India, quality as a factor has worked well especially since the Great Financial Crisis of 2008. During the tumultuous market conditions of that period, some stocks outperformed others by a wide margin and a common thread that connected these were their superior profitability, margin and debt indicators. This has also drawn attention to the factor leading to its incorporation into most investment processes.

We must note that the quality indices do not capture a homogenous source of risk and/or driver of returns and in fact these indices may themselves be construed as multi-factor portfolios that are exposed to multiple quality specific elements such as profitability, leverage, accruals etc.

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