Quality explained: Putting theory into practice

In the previous blogs of this series, we covered the varying definitions of the quality factor and the relationship between quality and value.

Now, we explore the potential benefits of quality, focusing on high profitability, low leverage and earnings stability.

Picking the right ingredients

The quality factor is based on fundamental analysis and is one of the newest important factors in investing. Choosing the right metrics to define a quality strategy is like creating a healthy meal; just as you select the best nutrients for a meal, you choose the best financial metrics for a quality strategy.

Common metrics to identify high-quality companies include high return on invested capital and low levels of financial manipulation. While empirical evidence exists of the outperformance of firms with such characteristics, risk-adjusted returns may be further improved using a combination of metrics.

Additionally, in a diverse portfolio, it's important to avoid biases that come from focusing too much on certain industries or regions. Therefore, the standardisation of quality metrics helps balance the portfolio, just like a well-balanced diet improves overall health.

The next sections explore how these considerations play into the design of a multi-dimensional quality screen and their impact on portfolio performance.

Chasing profitability

Return on investment capital (ROIC) measures the ability to generate returns from shareholders’ capital. ROIC is a more robust probability metric than other common metrics which may result in misleading selection screens. For example, return on equity (ROE) can be significantly influenced by leverage.

Similarly, net profit margin reflects a firm’s ability to manage its expenses and measures the profit that goes towards common shareholders.

The repeatability and sustainability of profitability

Low debt-to-equity (D/E) ratios are often a signal of strong financial management and modest risk. For example, Apple* displays strong cash flows, reflected in its consistently low D/E ratio, which the company may use to invest in R&D.

Accruals are balance sheet items that represent the unrealised gains or losses of the business. Lower accruals may suggest higher earnings quality, indicating profits being closely aligned with cash flows. In 2023, Alphabet* reported low levels of accruals[1], which can be attributed to the company’s main source of revenue being advertisements that are usually recognised in line with cash receipts.

A third indicator is the variability of earnings, with low earnings variability often desirable for long-term investors. For example, a company operating across various consumer segments – from personal care to food and beverages – can maintain stable earnings in various macro environments.

The quality of quality

Profitability isn’t the whole quality story. The potential performance and risk-mitigation benefits of a composite quality screen can be seen below, where we compare profitability-only screened portfolios and composite-quality screened portfolios.[2]

We’ve demonstrated the historical risk/return benefits of a composite screening approach to quality.

Ultimately, by focusing on the quality of quality, we believe investors can achieve improved risk-adjusted returns with a healthy and balanced portfolio.

 

*For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

[1] Yahoo Finance

[2] Top Decile Profitability-Only Screened Portfolios are constructed based on profitability metrics: ROIC and net profit margin. Top Decile Composite Quality Portfolios are constructed based on composite quality metrics: ROIC, net profit margin, debt-to-equity, accruals and earnings variability