Differing Definitions Of Quality

The 1997 publication of Mark Carhart’s paper, “On Persistence in Mutual Fund Performance,” led to the four-factor model (which added momentum to market beta, size and value) becoming the workhorse model in finance. The next major contribution came from Robert Novy-Marx. His 2012 paper, “The Other Side of Value: The Gross Profitability Premium,” provided investors not only with new insights into the cross section of stock returns, but it helped further explain Warren Buffett’s superior performance.

Researchers have since extended the profitability factor to a broader quality factor (the returns to high-quality companies minus the returns to low-quality companies) that captures a larger set of quality characteristics. While there is not yet one consistent definition of quality, in general, high-quality companies have the following traits: low earnings volatility, high margins, high asset turnover (indicating the efficient use of assets), low financial leverage, low operating leverage (indicating a strong balance sheet and low macroeconomic risk) and low specific stock risk (volatility unexplained by macroeconomic activity).

Read the rest of the article on ETF.com.

©2017 Advisors Showcase