What is quality investing?
Quality investing is an investment strategy that focuses on financially sound companies that have a history of solid earnings.
Investing in quality companies is an approach that can be traced back to world-renowned Economist and mentor to Warren Buffet, Benjamin Graham. In his book The Intelligent Investor first published in 1949, Graham said investors should demand from a company “a sufficiently strong financial position and the potential that its earnings will at least be maintained over the years.”
Such companies, Graham stated, show resilience by falling less in a downturn and recovering to previous highs quicker than other companies. Numerous academic research supports this. Analysis also shows that while a quality investing approach does tend to behave defensively in downturns, this approach also tends to perform strongly in bull markets. This is why quality investing is known as a strategy for “all seasons”.
What makes a quality company?
A focus on high quality companies has been the goal of many fundamental investors. While definitions vary, quality is commonly associated with a company’s competitiveness, efficiency, profit growth, financial and operating leverage, and return-on-equity (ROE).
According to investment research firm and index provider, MSCI, quality companies can be identified by three key quality factors:
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High return on equity
Identifiable metric: Return on equity - shows how effectively a company uses investments to generate earnings growth. -
Low leverage/low debt
Identifiable metric: Debt to equity – a measure of company ‘leverage’, which refers to the extent to which a company relies on borrowed funds, typically debt. -
Stable earnings growth
Identifiable metric: Earnings variability – how smooth recent earnings growth has been.
Read more about MSCI’s approach to quality here.
Academic research that supports quality investing
The quality factor is described in academic literature as companies with durable business models and sustainable competitive advantages. Nobel Laureates Eugene Fama and Kenneth French, in their seminal paper titled A Five-Factor Asset Pricing Model highlight the “Quality Premium”. Economist Robert Novy-Marx is another well-known proponent of quality investing. In his paper Quality Investing, Robert Novy-Marx set out to identify quality by assessing the best-known quality strategies. MSCI based its Quality Indices, launched in December 2012, on the principles of the best performing quality strategy in his paper.
Research that analysed the performance of quality companies
Author(s) | Quality aspect | Findings |
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Benjamin Graham (1937) |
Profitability, earnings quality (stability) |
|
Richard Sloan (1996) |
Earnings quality |
|
GMO white paper (2004) |
Profitability, stable earnings, low debt |
|
Robert Novy-Marx (2012) |
Profitability |
|
Max Kozlov and Antti Petajisto (2013) |
Earnings Quality |
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Clifford S. Asness, Andrea Frazzini, and Lasse H Pedersen (2013) |
Profitability, growth, safety, payout |
|
Eugene F. Fama, Kenneth R. French (2014) |
Quality and profitability |
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