Quality may seem like a relatively new concept for market participants that are already familiar with factors such as market risk, momentum, value, size, and growth. However, the idea of applying quality to investment decisions can be found in the philosophy of Benjamin Graham—nowadays considered the father of value investing. Indeed, five of the seven quality and quantity measures Graham advocated using when assessing a firm concerned the quality of the firm in question.
Some may find this surprising, especially because many value strategies today focus on valuations exclusively. Intuitively, though, the quality dimension of value provides a lens through which it may be possible to identify undervalued stocks—rather than simply the cheapest—by assessing underlying business characteristics, such as financing requirements and profitability. For this reason, quality is often considered an alternative to growth investing, focusing on companies that exhibit signs of above-average growth, even if those companies may be more expensive than some of their counterparts.
The S&P Quality Indices Methodology uses three metrics to capture quality.
1) The return on equity (ROE), which is calculated as a company’s trailing 12-month earnings per share divided by its latest book value, gives an indication of a firm’s profitability. Companies that provide a greater return using market participants’ capital may be more likely to achieve above-average growth.
2) The financial leverage ratio, which is computed by dividing a firm’s latest total debt by its book value, assesses the ability of a company to meet its financing obligations. Companies with less leverage should have more capital to invest in the underlying business, which could increase the growth rate.
3) The accruals ratio, which is the change in a company’s net operating assets over the past year divided by the average net operating assets over the past two years, provides an assessment of the operating performance of the firm, excluding impacts from financing decisions. Firms with higher accruals ratios are likely to be more profitable and may achieve higher-than-average returns.