Long-term investors want to invest in high quality businesses. The research paper Quality Minus Junk by Asness, Frazzini, and Pedersen defines quality as stocks that are “safe, profitable, growing, and well managed”.  This article examines the research done in Quality Minus Junk.

Quality Criteria

In Quality Minus Junk, 4 distinct criteria are used to quantitatively measure quality. Each is listed below along with a brief definition. The study was back tested from 1956 to 2012:

Profitability: Profitability is measured in multiple ways including gross profits, margins, accruals, and cash flows. The idea is that highly profitable stocks are better than barely profitable (or unprofitable) stocks, all other things being equal. The actual criteria used are:

• Gross Profits / Assets
• Return on Equity
• Return on Assets
• Cash Flow over Assets
• Gross Margin

Growth: Growth is measured as the average 5 year growth in each of the profitability measures. The idea is that faster growth is better than slower growth, all other things being equal.

This method of growth is unusual in that it is really exploring growth in profitability or margins, rather than traditional growth in earnings per share, book value, or dividend payments.

Safety: Safety is measured using stock price beta and volatility, low leverage, low credit risk, and low earnings variability. The idea is that stable, safe stocks make better investments then unstable risky stocks, all other things being equal. The actual criteria used are:

• Idiosyncratic price volatility
• Beta
• Leverage
• Z-score
• O-Score
• Return on Equity volatility

Payout: Payout is measured using the payout ratio.  Additionally, share issuance and dilution is considered as well. The idea is that the more cash flows a stock returns to shareholders, the better, all other things (including growth) being equal. The actual criteria used are:

• Net equity issuance
• Net debt issuance
• Payout ratio

Using the criteria above, the study came to several interesting conclusions. Three powerful conclusions are discussed below.

High Quality Stocks Outperform

The highest quality 10% of stocks had an average annualized return of 7.6% in excess of treasury bills. Stocks were value weighted, meaning lower P/B stocks made up higher percentages of the portfolio.  For comparison, the average excess return of the S&P 500 has been about 4.7%. High quality stocks have outperformed the market by an average of about 3% a year since the 1950’s.

It is important to note that high quality stocks do not outperform every year. They experience periods of underperformance; specifically strong bull markets like the tech bubble of the late 1990’s.

High Quality Stocks Perform Well In Recessions

High quality stocks generated the most alpha during recessions. High quality stocks fall during recessions.They tend to fall less than lower quality stocks, however. This is because high quality stocks have more stable business models and competitive advantages which helps reduce earnings draw downs during recessions.

High Quality Stocks Tend To Remain High Quality

Interestingly, high quality is persistent. The same stocks tend to remain high quality. If one took the 10% highest quality stocks, and held them for 10 years, those 10% of stocks would still have the highest quality score compared to other stocks 10 years later. This makes high quality stocks especially relevant for buy and hold investors.

High quality stocks tend to remain high quality. Interestingly, the data in the paper shows that low quality stocks revert to about average quality over long periods of time.

Final Thoughts

Investors have a choice of what stocks they buy. Common sense says that being businesses that have historically performed well should generate strong returns. Academic research backs up this simple conclusion. High quality stocks have historically generated higher returns with lower risk.  Additionally, high quality stocks tend to stay high quality for years making them especially suitable for buy and hold investors.