As a noun, the quality of an item refers to how good or bad it is.
In popular usage however, the word "quality" has retained only positive connotations being used most often as a simile for "high quality". A "quality product" is assumed to be a high quality product and a “quality company” is understood to mean a high quality company. It is almost always used relationally signifying the standing of one in comparison to others of a similar nature.
But how does one define a quality company compared to its peers? Mostly companies that exert greater control over their markets for purchases and sales, with controlled costs and a high degree of strategic & financial flexibility are considered to be quality companies. Measuring the quality factor, though, comes with its own unique challenges.
The one thing that sets quality apart from all the other factors is that it has no relationship with the prevailing price of the stock. It relies completely on non-market information, typically the financial statements released by companies periodically.
In the context of factor investing, the quality factor can be captured using multiple fundamental ratios calculated using companies’ financial statements, such as Return on Equity (ROE), Return on Assets (ROA), Gross Margin, EPS Growth, and Leverage to name a few.
It can be logically inferred that informed and rational investors would be willing to pay a premium for companies that possess high quality businesses with many of the above mentioned characteristics. This is commonly referred to as the Quality Premium or Quality Effect and signifies the potential of high quality stocks to outperform their lower quality counterparts over long periods of time.
It is important to note that unlike value, volatility or momentum, there is no one-size-fits-all definition for quality factor and different academicians and professionals may have developed different definitions of quality. In other words, while one may find companies with high gross and operating margins to be of superior quality, someone else may prioritise low leverage and high ROE over high gross margins.