- Our research shows higher returns don’t necessarily come with higher risk.
- Higher-quality stocks as defined by Northern Trust’s Quality Score tend to outperform lower-quality stocks and do so with considerably less risk.
- We believe that a quality definition must be multidimensional and have strong performance across a wide range of measures.
Although it seems logical that higher-quality companies would have better long-term performance, the concept itself is somewhat intangible and subjective. As such, there are disparate opinions across the industry on what “quality” means.
The search for a common definition or core theory has been far from universal, as some financial practitioners and academics focus on return on equity (ROE) and debt-to-equity, while others focus on earnings and dividend metrics. There seems little agreement on how best to determine the quality of a company.
“Unlike other equity factors such as value or size, there is no generally agreed upon definition of quality,” said Michael Hunstad, head of quantitative research at Northern Trust. “Despite years of research, the finance community has made little headway in developing a core theory of equity quality.”
Perhaps it would be valuable to step back and consider the multiple facets of a quality company, and how best to analyze them. Profitability, management efficiency, prudent capital structure and cash flow all might have relevance to the performance of a company.
In its research on the characteristics and performance of higher-quality companies, Northern Trust found that higher returns didn’t necessarily come with higher risk. In fact, the opposite was true. This important finding may seem counterintuitive to adherents of the Capital Asset Pricing Model (CAPM), which asserts that return and risk are closely related and that to get higher returns, you need to take on increased risk. The big question is why would high-quality stocks command a premium? The key reason we feel is that CAPM assumes that all investors are risk averse and respond in a homogenous way — we would argue that the investor population includes both risk-averse and risk-seeking investors all responding differently to equity markets.
High-quality stocks outperform low quality because low-quality/high-volatility names are relatively expensive versus high-quality/low-volatility names. Risk-seeking investors bid up the price of low-quality stocks to the point they are bound to underperform. The risk-seeking objective is to capture the large potential upside even though it means introducing more uncertainty.
Northern Trust’s Quality Score
Even if the industry has not yet settled on a clear definition of what quality is, there is ample evidence of what quality does. Northern Trust has evidence to state that “quality” includes those features of a company that particularly appeal to risk-averse investors. While lacking specifics, this definition gives us an intuitive framework with which to think about constructing a quality measure. Northern Trust’s research has led to an emphasis on features that appeal to these risk-averse investors, including profitability, cash flow, solvency and an ability to pay dividends.
The Northern Trust Quality Score (NTQS) is a proprietary method that gauges multiple dimensions of quality grouped under the headers of Management Efficiency, Profitability and Cash Flow. These signals are based on our fundamental belief that a quality company should encompass characteristics such as the ones detailed below, among others.
Based on the NTQS, Northern Trust created factor-mimicking portfolios for a variety of alternative quality definitions (see below). These factor-mimicking portfolios are defined as the returns net of Fama-French-Carhart factors of the highest quality (first quintile) stocks minus the net returns of the lowest quality (fifth quintile) stocks. The objective of the factor-mimicking portfolio is to proxy the true return of the quality factor, independent of aggregate market movements.
“By incorporating a Northern Trust Quality overlay into an equity portfolio, investors have the opportunity to achieve stronger risk adjusted returns,” said Matt Peron, managing director of global equity at Northern Trust.
To learn more about the Northern Trust Quality Score and how to use it within your equity portfolio, please contact your Northern Trust relationship manager, or read “Insights on Quality Investing,” at northerntrust.com.