Clarifying Quality: How to Spot a Real Value Stock

Jargon-busters take note: S&P Dow Jones Indices has attempted to define once and for all what is meant by a “quality stock”.

Defining quality as a risk factor has been “unsatisfyingly nebulous” so far, a report from the group said, despite its ability to contribute to performance separate from the “classical risk factors”—size, momentum, volatility, and value. Industry experts have yet to agree on not only the meaning, but also the metrics used to identify high-quality stocks.

“The aim of any quality measure should be to assist in estimating a company’s future profitability and the source of risk to which it is most subjected,” authors Daniel Ung, Priscilla Luk, and Xiaowei Kang said.

“High-quality companies are seen as those that can keep a steady course in times of crisis by the fact that their earnings would generally be less sensitive to the volatility of the business cycle,” S&P Dow Jones Indices said.

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According to S&P, one could pinpoint high-quality companies using return-on-equity (ROE), balance sheet accruals ratio, and financial leverage.

The report argued that ROE was an effective measure of a company’s profitability. S&P data revealed companies with high ROE—measured by examining the company’s 12-month income scaled by book value—tend to perform well and were expected to remain profitable in the future.

The accruals ratio could be used to estimate a company’s stock returns across different markets, the report said, determining how earnings reflected the strength of a firm. It also emphasizes a company’s cash earnings, S&P contended.

And finally, the report said measuring financial leverage could help determine a company’s ability to reduce risk in times of market volatility.

The report also found stocks valued as high-quality using these standards outperformed low-quality counterparts on an absolute and a risk-adjusted basis for a long period of time.

According to the firm’s data, from 2000 to 2013 S&P Quality Indices beat their market-cap weighted benchmarks. The outperformance was most staggering in the US, topping their benchmarks by 5.4%. They also displayed lower return volatility and lower maximum drawdowns than their benchmarks.

The S&P Quality Indices provided downside protection in bear markets—consistent with their good performance during slow economic growth—but fell slightly in bull markets. However, the report said the significant excess returns during bad times contributed to high-quality stocks’ outperformance over the long term.

Read the full paper here.

Related Content: Risk Parity Losing to Risk Factors, Study Finds

Firms highly invested in innovation allocated more to private equity while companies with large land holdings invested heavily in real estate, according to a study.

Company characteristics could influence where capital is allocated in their corporate defined benefit (DB) plans, research has found.

According to a study, pension plans sponsored by firms with high innovation expenditures invested more in private equity in their DB plans. And those with large land and building holdings allocated heavily to real estate.

“Such alternative investment tilts result in private equity and real estate being overweighted relative to the average and median pension asset mix,” said Christina Atanasova, of Simon Fraser University in Canada, and Gilles Chemla, at the Imperial College Business School in London. “The links between the sponsors’ characteristics and the pension plan’s alternative assets remain robust.”

Specifically, the study found that one standard deviation increase in the ratio of research and development (R&D) expenses to capital led to an increase of more than 0.45% in a plan’s private equity investments. Sponsors in the top quartile of R&D expenditures invested twice as much in the asset class than those in the bottom quartile, the authors said.

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For firms with large land and building holdings, one standard deviation increase in holdings led to a jump of more than 0.75% in allocation to real estate investments. The study also found firms in the top quartile of land and building holdings invested 15% more in real estate than those in the bottom quartile.

Moreover, the authors argued that there existed a “familiarity bias” in alternative investment tilts as statistics showed that firms became increasingly allocated to private equity investments in their pension plans after diving into R&D. The same was true for firms with land and building holdings and real estate.

However, Atanasova and Chemla said pension plans with such alternative tilts underperformed the median DB plan when measured for excess returns. According to research, funds sponsored by firms in the top quartile of R&D lagged far behind in abnormal return on private equity than those in the bottom quartile.

Read the full paper here.