The S&P 500 (INDEXSP:.INX) established its family of Quality Indices last week, arguing that quality is a risk factor distinct from size, value, momentum, low volatility that can be defined as a combination of other risk premia. While there may be broad agreement on whether a specific company is high quality, coming up with a quantitative measure that everyone can agree with is another matter. Fortunately, S&P Dow Jones Indices researchers Daniel Ung, Priscilla Luk, and Xiaowei Kang explain how the new indices measure Quality in a recent white paper (h/t AI-CIO).

Quality as a combination of profitability, earnings, and low leverage

Ung, Luk, and Kang argue that a high quality firm should be consistently profitable, have high earnings quality, and be robust during times of economic stress. The terms feel reverse engineered to match the financial criteria that they’ve settled on – return on equity (ROE), balance sheet accruals (BSA) ratio, and leverage – but they’re also a reasonable place to start.

ROE is a pretty standard way to measure profitability, but it also has the advantage of being fairly persistent: high ROE today is a good indication of high ROE next year, though the opposite isn’t always true. The downside is that ROE is widely used and you would expect it to already be priced in.

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The paper defines BSA ratio as the change in net operating assets over the last twelve months divided by the average net operating assets over the same period. Basically what this tells you is how much of a company’s growth is from cash coming in the door and how much is from accounts receivable, goodwill, and other factors that a company might use to manage its results. A high BSA ratio doesn’t necessarily mean that something is wrong, but it is a red flag and the S&P paper found that companies with a low BSA ratio tend to outperform. They also found that the result holds when applied to financial companies, even though their balance sheets look very different from non-financial sectors.

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The use of low leverage as a sign of high quality is probably more contentious. Too much debt can cripple a company by limiting its options, but most investors don’t want companies to skip on attractive deals because they’re not willing to finance it either.

“Lowly-geared companies beat highly-geared ones by about 1% per annum (p.a.), but this outperformance is unremarkable vis-à-vis the reduction in return volatility (by about 3% p.a.), which may imply that lower indebtedness offers companies downside protection,” they write. “In calmer markets, companies with less gearing often tend to lag behind those with high gearing, but they usually prevail in financial downturns, as their ‘safer’ characteristics come to the foreground.”

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Quality stocks seem to be slightly mispriced by the market

“Nevertheless, the concept of being rewarded for owning high-quality stocks may seem to defy logic, as risk premia are usually offered for assuming some form of risk,” write Ung, Luk, and Kang.

One possible explanation is that people there are enough people looking for big wins, instead of steady gainers to hold for a long time, means that high-quality, low-risk companies are slightly mispriced by the market. Whatever the reason, backtesting the S&P Quality indices show that they beat their respective benchmarks almost across the board.

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