Defining Quality
Unlike value or momentum, "quality" lacks a consensus definition. Various practitioners and academics have proposed different metrics, all aiming to capture companies with superior fundamentals. This ambiguity creates both challenges and opportunities—the factor's efficacy depends critically on construction choices.
Quality's Resilience
Quality has been one of the most consistent factors in recent years, outperforming during the growth drawdown of 2022 and providing stability when value and momentum struggled. Understanding why requires examining what quality actually captures.
Common Quality Metrics
We evaluate several widely-used quality indicators:
Profitability Measures
- Return on Equity (ROE): Net income / shareholders' equity
- Return on Assets (ROA): Net income / total assets
- Gross Profitability: (Revenue - COGS) / assets, per Novy-Marx
- Operating Profitability: Operating income / book equity
Stability Measures
- Earnings stability: Inverse of earnings volatility over 5 years
- Low accruals: Companies with cash-based earnings
- Dividend consistency: Track record of stable/growing dividends
Safety Measures
- Low leverage: Debt/equity or debt/assets
- Interest coverage: EBIT / interest expense
- Low beta: Market sensitivity as proxy for business risk
Construction Approaches
We compare four quality portfolio construction methodologies:
Single-metric (Gross Profitability): Simple and transparent, but ignores other quality dimensions.
Composite score: Equal-weight combination of profitability, stability, and safety metrics. More robust but requires subjective weighting choices.
Sector-neutral: Apply quality screens within sectors rather than across the market. Reduces sector bets but may miss cross-sector quality dispersion.
Quality-at-reasonable-price (QARP): Combine quality with valuation filters to avoid overpaying for quality. Addresses the criticism that quality is expensive.
Empirical Results
Across our testing period (2000-2025), we find:
- Composite approaches outperform single-metric by 1.2% annually
- Sector-neutral construction reduces volatility by 15% with modest return sacrifice
- QARP improves Sharpe ratio by 0.08 versus pure quality
- Gross profitability remains the single best metric for simplicity
Conclusion
Quality factor portfolios can be constructed in many ways, and construction choices meaningfully impact performance. We favor composite approaches that combine multiple quality dimensions with sector-neutral implementation, accepting modest complexity for improved robustness. For simpler implementations, gross profitability remains the single most effective metric.