It has long been known that high quality companies outperform junk companies in the stock market. It makes sense doesn't it? Profitable companies generating sustainable cashflow at high rates of return really ought to be better investments than companies that are constantly loss making and eating shareholder's funds. Of course this is an open secret, and high quality companies generally become bid up to higher valuations over time. The trick is to find high quality companies at bargain prices. As Warren Buffett once said "When it comes to socks or stocks, I like buying high quality merchandise when it is marked down".
Our approach to calculating the QualityRank mirrors that taken for the ValueRank, MomentumRank and GrowthRank scores. Our QualityRank is based on a composite of carefully selected company factors based on the latest academic research into understanding 'Quality'. The factors used are inspired by the writings of Warren Buffett, Joseph Piotroski, Edward Altman and Messod Beneish, as well as recent papers from Robert Novy-Marx of the University of Chicago and National Bureau of Economic Research.
Each company in the market is ranked from 1 to 100 for each of these Quality Factors and a composite score is calculated as a weighted average of all these values. The QualityRank™ is then calculated between zero and 100 for this composite score, where 100 is best and zero is worst.
Is the company a stable, growing, cashflow generative business with high returns?
- Long Term Average Return on Capital Employed
- Long Term Gross Profits to Assets - (made famous by Robert Novy-Marx)
- Long Term Average Free Cashflow to Assets Ratio
- Long Term Operating Margin Stability
- Long Term Sales Growth Consistency
In which direction are the company's fundamentals headed?
- Piotroski F-Score (discussed in depth here) - We heavily weight the F-Score given it's effectiveness, especially amongst small caps.
Is there a risk to your capital investing in this company?
- Altman Z-Score, a bankruptcy meter (discussed in depth here)
- Beneish M-Score, an earning manipulation flag (discussed in depth here)
- Current Leverage (Net debt to assets)
It should be noted that the QualityRank is very specifically designed to be 'predictive' rather than 'descriptive' of future returns. Some companies may score very highly because they are rapidly improving, but have not very exciting historic profitability records. This is to be expected. Many Quality grading algorithms, especially those constructed by major finance firms are designed to describe a company. This frankly isn't useful for predicting future stock market returns as the stock market tends to discount descriptive information quite adeptly. It is less adept at discounting trends which is what we try to focus on.
There are some great academic research studies in the public domain on the topic of corporate Quality. Do try Googling the names of any of the above mentioned academics. Beyond that here are some standout studies.
Asness, Frazzini and Pedersen, of the giant hedge fund AQR Capital, released the excellent study called 'Quality Minus Junk' which completely states the case for investment in Quality firms.
In his paper, The Other Side of Value, Novy-Marx found that quality firms (i.e. those with high profitability) have historically outperformed lower quality firms after accounting for other known characteristics that predict relative returns like the size of a company and valuation. In his work, the premium appears to be roughly the same size as the value premium.
It's also worth reading this paper by Novy-Marx which explores the interaction of Value, Quality and Momentum.