Quality Factor - US

Approach

We used the generally accepted assumption of high quality companies:

1. High quality companies are effective at generating profits. They have strong profit margins and generate a high return on equity (ROE). Often, this profitability is a result of a specific competitive advantage.
2. High quality companies demonstrate a track record of consistent business performance. They have stable revenues, profits, and cash flows, and they consistently demonstrate growth throughout the economic cycle.
3. High quality companies have financial strength. They have strong balance sheets and ample liquidity and as a result, are generally less vulnerable during economic downturns as they are able to withstand adverse conditions.

Factors Evaluated

The quality factor considers three sub factor groups: profit, growth, and safety:

Profit

Return on equity (ROE)

Return on assets (ROA)

Gross profits to assets

Cash flow to assets

Gross margin

Percentage of earnings composed of cash

Growth

The change in ROE over five years

The change in ROA over five years

The change in gross profit to assets over five years

The change in cash flow to assets over five years

The change in gross margin over five years

Safety

Total debt over assets

Market beta: a measure of a stock’s volatility relative to the market

Ohlson O-score

Altman Z-score

The standard deviation of quarterly ROE over the past five years

Methodology

We applied the aforementioned quality metrics to a universe of the largest 500 US equities by market capitalization and ranked each stock on its overall quality. We then divided the universe into 10 quantiles of stocks, with the top quantile (Q_10) representing the highest quality stocks and the bottom quantile (Q_1) representing the lowest quality stocks.

For a long strategy, the top quantiles (Q_8 - Q_10) are the most useful, while for a short strategy, the bottom quantiles (Q_1-Q_3) are the most useful.

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