The quality factor has spent plenty of time in the spotlight this year and rightfully so. That theme could continue in 2020 as investors mull the impact of potential political volatility in the U.S. while continuing to eschew unprofitable, newly public startup-type companies.
Investors looking to efficiently access a basket of large-cap, domestic quality stocks may want to consider the FlexShares US Quality Large Cap Index Fund (CBOE: QLC).
QLC selects and weights companies based on management efficiency, profitability, and cash flow to determine quality, according to FlexShares. Management efficiency is a quantitative evaluation of a firm’s deployment of capital and its financing decision. Profitability scores help weed out firms with wider margins, which may be better positioned to grow. Lastly, cash flow signals the liquidity level of a company. Those with higher cash flows may be better situated to take advantage of potential opportunities or enjoy a financial cushion in downturns.
Multiple Versions of Quality
There are multiple ways of defining quality, making it somewhat misunderstood relative to rival factors, such as value and low volatility. However, there are some hallmarks of quality that usually easy to identify.
“Quality can be defined a lot of different ways. Stellar balance sheets, for instance. Steady earnings and returns on capital. And efficiency, whereby sales are consistently turned into profits,” said Morningstar in a recent note.
QLC skirts value traps by including momentum characteristics, which will be determined through a stock’s price history to capture a picture of the recent performance and by using analysts analyst outlooks to get a sense of future sentiment regarding a company. About half of QLC’s holdings are classified as value stocks.
Related: A Very Winning Idea Among Quality ETFs
“Morningstar defines quality companies as those that can outearn their costs of capital for a decade or more. They can do so because they possess competitive advantages, which are encapsulated in the Morningstar Economic Moat Rating,” according to the research firm.
About 46% of QLC’s holdings are also classified as value stocks. The fund allocates 24.45% of its weight to technology stocks and over 27% of its combined weight to the healthcare and financial services sector.
QLC is up 18% this year.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.