Quality Minus Junk

Asness, C. S., Frazzini, A., & Pedersen, L. H. (2019). Quality minus junk. Review of Accounting Studies, 24(1), 34-112.

Review

  • Quality Security : stocks that are safe, profitable, growing and well managed.
  • high quality : higher prices on average, but not by a very large margin
  • A quality-minus-junk(QMJ) factor that goes long high-quality stocks and shorts low-quality stocks earns significant risk-adjusted returns in the U.S. and globally across 24 countries
  • price-to-book value

\[ \frac{P}{B}=\frac{profitability \times payout.ratio}{required.return - growth} \]

→ scale prices by book values to make them more stationary over time and in the cross section

  • profitability : profits per unit of book value

    • measure profits in several ways, including gross profits, margins, earnings, accruals, cash flows, stock's average rank across these metrics

  • growth : 5-year growth in each of profitability measures

  • safety : consider both return-based measure of safety (market beta & volatility) and fundamental-based measures of safety (low leverage, low volatility of profitability & low credit risk)

  • payout : the fraction of profits paid out to shareholders

→ a measure of shareholder friendliness

→ higher payout is associated with a lower future profitability or growth

  • They need to be persistent !!!

  • a long sample of U.S. stocks from 1956 to 2012 & broad sample of stocks from 24 developed markets from 1986 to 2012

  • The explanatory power of quality on price is limited as the average R2 is only 12% in the long sample and 6% in the broad sample.

    • market prices fail to fully reflect these characteristics for reasons linked to behavioral finance or constraints
    • market prices are based on superior quality characteristics than the ones we consider
    • the quality characteristics are correlated to risk factors not captured in out risk adjustment

  • QMJ strategy and HML standar value strategy are negatively correlated.

    • QMJ is buying and selling based on quality characteristics irrespective of stock prices, while HML is buying based on stock prices irrespective of quality
    • Two concepts combined in "quality at a reasonable price (QARP)" : "investment must always the price as well as the quality of the security"
    • QARP is stronger than HML alone as quality is positively associated with future returns, and negatively correlated with value.

  • In summary, we complement the literature by showing (i) the theoretical price of quality in a dynamic model; (ii) how quality affects price multiples and how much of the cross-sectional variation of price multiples can be explained by quality; (iii) that the price of quality varies over time and predicts the future return on quality factors; (iv) that quality stocks earn higher returns and yet appear safer, not riskier, than junk stocks, benefitting from flight to quality; and (v) that analysts’ target prices and earnings forecast errors imply systematic quality-related errors in return and earnings expectations.