Quality explained: a price worth paying?

Having explained the academic foundations of the quality factor in our previous blog, let’s now consider these strategies in a practical setting.

It’s commonly known that quality strategies are typically long-term strategies with defensive characteristics. These include potentially lower drawdowns, which can be explained by the ‘flight to quality’ of investors shifting their allocations towards lower-risk more stable companies with robust business models during periods of market downturn or economic slowdown.

Over the past two decades this strategy has paid off. Below we show the performance of three rules-based US quality strategies, all of which demonstrate outperformance against a widely followed mid- and large-cap index.

“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett

Quality factor strategies can often be more expensive than the broad market or value strategies, which seek companies with attractive valuations based on fundamental analysis.

An everyday analogy for looking for quality stocks is scanning the discount aisle of the supermarket in hopes of finding organic produce at the same price as conventional stock. So, how can investors aim to identify ‘cheap’ quality opportunities in cyclical economic environments?

The quality premium goes in cycles and so does its valuation. The graph shows that from 2002 to 2007, high-quality stocks displayed higher valuations until the global financial crisis in 2008, when quality stocks became more attractive based on earnings multiples. During the 2008 financial crisis and the recovery until 2013, you could get even better quality stocks for cheaper prices. Since 2013, the valuation of quality stocks has gradually increased.

Quality in industry sectors

Of course, like any other strategy, quality is dynamic over time, reflecting the economic and market conditions that are unique to each point in time. We can observe these dynamics by looking at the sectors which include more quality characteristics.

One observation is that the financial sector, which showed strong profitability prior to the 2008 crisis, declined a little in terms of quality and gave way to the technology sector prior to recovery. These two sectors have mostly been the two top quality sectors since.

Another example is the oil & gas industry, which in 2006-2009 ranked highly in terms of quality due to the profitability of its key companies. Lastly, it’s noteworthy that sectors such as consumer services and industrials have benefited from the recovery and expansion post the financial crisis, which has endured even in the COVID-19 era, with strong earnings and increased profitability.

We have explored some characteristics of quality and how they have evolved over time, which illustrate the cyclical nature of the quality premium and its key components.

In the next instalment of this blog, we’ll explore how systematic quality strategies can be designed with the aim of optimising their risk-adjusted returns.