Stock Quality and Future Returns

Are high-quality stocks worth the price? In the June 2017 update of their paper entitled “Quality Minus Junk”, Clifford Asness, Andrea Frazzini and Lasse Pedersen investigate whether high-quality stocks outperform low-quality stocks. They define high-quality stocks as those that are profitable, growing, safe and well-managed. Specifically, they compute a single quality score for each stock by averaging scores for three components calculated as follows:

• Profitability – average of rankings for (high) gross profits/assets, return on equity, return on assets, cash flow/assets, gross margin and fraction of earnings that is cash.
• Growth – average of rankings for (high) prior five-year growth rates for each of the six profitability measures.
• Safety – average of rankings for (low) market beta, idiosyncratic volatility, leverage, bankruptcy risk and volatility of return on equity.

They consider two modes of analysis: quality-sorted portfolios and quality-minus-junk (QMJ) long-short factor portfolios. Quality-sorted portfolios are by value-weighted tenths (deciles), reformed at the end of each calendar month. QMJ factor portfolio return is the average return on two value-weighted top 30% of quality portfolios (big stocks and small stocks separately) minus the average return on two value-weighted bottom 30% of quality portfolios (big stocks and small stocks separately), reformed monthly by sorting first on size and then on quality. For both modes, global portfolios are value-weighted composites of country portfolios in U.S. dollars. Using characteristics and returns for a broad sample of U.S. stocks since June 1957 and samples of stocks from 24 developed markets (including the U.S.) since June 1989, and contemporaneous U.S. Treasury bill yield as the risk-free rate, all through December 2016, they find that:

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