Quality Factor Investing: Screen for Profitable Stable Companies

Key Takeaways

• Quality factor investing scores stocks on profitability, earnings stability, and leverage then overweights the top tier in a long-only equity portfolio.
• Novy-Marx's 2013 paper showed gross profitability, revenue minus COGS divided by assets, has roughly the same predictive power as book-to-market.
• Relying on a single quality metric is the most common construction error, return on equity alone can be inflated by leverage and misleads.
• Quality tilts add defensive characteristics to a portfolio, reducing drawdowns during cycles when leveraged or unprofitable firms suffer most.

What It Is

"Quality" has no single definition. Different index providers and asset managers use different ingredients, but most include some mix of:

• Profitability: gross profits to assets, return on equity, or return on invested capital.
• Earnings stability: low variability of earnings or margins across cycles.
• Balance sheet strength: low leverage, low accruals, conservative investment.
• Payout discipline: sensible dividends and buybacks, low share issuance.

Novy-Marx's 2013 paper "The Other Side of Value" argued that gross profitability, defined as revenue minus cost of goods sold divided by total assets, captures most of what investors mean by "quality" and has roughly the same predictive power for future returns as book-to-market.

The Intuition

A cheap stock with shrinking margins and a stretched balance sheet is often a value trap. A profitable, cash-generative company that reinvests at high returns compounds book value over time and tends to beat expectations. The quality premium is the market's tendency to underprice durable profitability.

Quality also explains why the two sides of Benjamin Graham and Warren Buffett's investing style are both right. Graham emphasised buying cheap. Buffett shifted toward buying good businesses at reasonable prices. Novy-Marx showed that profitability and value are separate dimensions and that combining them captures more return than either alone.

How It Works

A simple long-only quality tilt works like a factor tilt described in the factor-investing article, but scored on profitability rather than book-to-market. The steps:

1. Define the universe, typically large and mid caps with enough liquidity.
2. Compute gross profitability, return on equity, or a composite score per stock.
3. Rank the universe and overweight the top tercile or quartile relative to the benchmark.

gross profitability = (revenue - cost of goods sold) / total assets
return on equity    = net income / average book equity
quality composite   = z-score average of profitability, stability, leverage

Most commercial quality indices blend three to five sub-metrics to avoid relying on a single accounting line. MSCI's quality index, for example, combines return on equity, debt-to-equity, and earnings variability. S&P's version uses return on equity, accruals ratio, and financial leverage.

Quality interacts usefully with other factors. Combining quality with value produces a "quality-at-a-reasonable-price" tilt that sidesteps value traps. Combining quality with momentum avoids buying falling knives. Dimensional, AQR, and several index providers run multi-factor products built around this interaction.

Worked Example

Consider two companies in the same industry. Company X has revenue of $10 billion, cost of goods sold of $6 billion, and total assets of $8 billion. Gross profitability equals ($10 - $6) / $8 = 0.50. Company Y has revenue of $12 billion, COGS of $9.5 billion, and assets of $15 billion. Gross profitability equals ($12 - $9.5) / $15 = 0.17.

On a price-to-book basis, Company Y is the cheaper stock at 1.2 times book versus Company X at 2.0. A pure value screen prefers Y. A quality screen strongly prefers X, because it produces three times the gross profit per dollar of assets. A quality-at-a-reasonable-price investor would compare both and likely buy X at 2.0 times book rather than Y at 1.2, because the expected future earnings power is larger despite the higher multiple.

Novy-Marx's empirical work showed that this type of trade would have historically earned positive alpha relative to standard value-only portfolios, particularly when measured on US equities from the mid-1960s through the mid-2000s.

Common Mistakes

1. Using one metric. Return on equity alone can be boosted by leverage. Gross profitability alone can miss working capital issues. Multi-metric composites are more stable.
2. Double counting with value. If your quality definition includes book-to-market indirectly, you lose the independence of the two factors. Stick to pure profitability measures for quality and let value carry valuation separately.
3. Confusing quality with low volatility. High-quality companies often have low realised volatility, but the factors are different. Quality is about fundamentals; low volatility is about price behaviour. Portfolios built on one are not equivalent to portfolios built on the other.
4. Ignoring capital-intensity effects. Quality scores tilt toward asset-light businesses like software and consumer brands. Heavy industrials with strong returns on invested capital can still screen poorly on gross profitability. Cross-sector applications need adjustments.
5. Paying any price for quality. Even the best business is a bad investment at a high enough multiple. Empirical studies show quality works best when combined with a valuation constraint, not as a stand-alone buy-at-any-price rule.

Frequently Asked Questions

Q: What is quality factor investing in simple terms? Quality factor investing means systematically overweighting profitable, financially stable companies and underweighting their unprofitable, leveraged counterparts, based on research showing this tilt earns excess returns comparable to the value factor.

Q: How does quality factor investing affect investment decisions? It adds profitability and balance-sheet screens that override raw valuation signals. A stock can look cheap on P/B but score poorly on gross profitability, steering a quality-tilt fund away from names that pure value screens would buy.

Q: What is a real-world example of quality factor investing? The article's comparison shows Company X with gross profitability of 0.50 versus Company Y at 0.17. Despite Y being cheaper on P/B (1.2x versus 2.0x), a quality-at-reasonable-price investor buys X because it earns three times the gross profit per dollar of assets.

Q: How can investors use quality factor investing in their portfolio? Combine at least three quality sub-metrics, profitability, stability, and leverage, to avoid gaming by any single accounting line. Pair the quality score with a valuation constraint to avoid paying any price for the quality label.

Q: How is quality factor investing different from quality investing generally? The broader quality investing article covers the fundamental approach to screening and owning quality companies. Quality factor investing specifically applies academic factor definitions, Novy-Marx's gross profitability, MSCI quality composites, to build systematic long-only tilts within a benchmark framework.

Sources

1. Novy-Marx, R. "The Other Side of Value: The Gross Profitability Premium." Journal of Financial Economics, 2013. https://oldschoolvalue-files.s3.amazonaws.com/pdf/Novy-Marx_Gross-Profitability-Anomaly_JFE_2013.pdf
2. Novy-Marx, R. "The Quality Dimension of Value Investing." University of Rochester/Ivey. https://www.ivey.uwo.ca/media/3775548/novy-marx.pdf
3. Novy-Marx, R., Velikov, M. "What Have We Learned." NBER Working Paper 33601. https://www.nber.org/system/files/working_papers/w33601/w33601.pdf
4. Alpha Architect. "The Profitability Factor: International Evidence." https://alphaarchitect.com/the-profitability-factor-international-evidence/

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.