Factory Investing: Understanding the Quality Factor

Factor investing, otherwise known as smart beta, is an investment strategy that falls at the intersection between passive and active investment management. The strategy seeks to gain exposure to various systematic historical drivers of stock performance, called “factors.” Common factors include: value, momentum, size, volatility and quality. Many investors have heard of these factors, but not all investors have a deep understanding for exactly how each one works.

This blog takes a closer look at one of the more complex factors: quality. As shown below, the Russell 1000 Quality Factor Total Return Index has outperformed the Russell 1000 Total Return Index by about 2.0% percent year-to-date.1

Russell 1000 Quality Factor Trends

What is the quality factor? Definitions for quality vary across the industry. Here at Deutsche Asset Management, in partnership with FTSE Russell, we define quality in terms of profitability and leverage. Accordingly, this factor seeks to identify stocks that exhibit persistent profitability and low leverage. Three metrics influence firm profitability and its persistence, namely: return on assets (ROA), changes in asset turnover, and accruals. On the other hand, a firm’s level of leverage is measured by using a ratio of operating cash flow to total debt. This blog takes a closer look at these metrics and how they pertain to determining a company’s quality.

Let’s begin with profitability. The term “profitability” is not the same as “profit”. Profit is an absolute number calculated as total revenue minus total expenses on the income statement. Whereas, profitability measures profit relative to the size of a business. In this sense, profitability measures the efficiency of a business in terms of how well it can produce a return on investment. Therefore, when seeking out a high quality company, the quality factor aims to identify firms that are profitable rather than those that simply have profits.

We are able to gauge a firm’s profitability by using the three aforementioned fundamental metrics. The first, ROA, is the most direct measure of profitability and it is calculated by dividing net income by total assets. ROA measures how well a firm deploys its underlying assets to produce earnings, and it assesses a firm’s overall level of profitability. All else equal, companies that exhibit higher ROA are considered more profitable than those with lower ROA. Historical data suggest that companies that exhibit current high levels of profitability also tend to exhibit future high levels of profitability (although this is not guaranteed). As such, the quality factor aims to overweight companies that exhibit high levels of ROA.

The second metric, change in asset turnover, is a way to understand not just profitability but improvements in profitability. Asset turnover measures a company’s sales relative to its asset base. In this sense, the ratio measures firm efficiency by indicating how many dollars of sales are generated per dollar of assets. Changes in this ratio provide insight into whether a company’s profitability is either strengthening or weakening. An increasing ratio suggests a company that is improving its efficiency, which should ultimately lead to improved profitability. Therefore, the quality factor seeks to overweight companies that exhibit improving asset turnover ratios.