Clarifying Quality: How to Spot a Real Value Stock

S&P Dow Jones Indices has outlined steps to identifying the Bentley of equities.

Jargon-busters take note: S&P Dow Jones Indices has attempted to define once and for all what is meant by a “quality stock”.

Defining quality as a risk factor has been “unsatisfyingly nebulous” so far, a report from the group said, despite its ability to contribute to performance separate from the “classical risk factors”—size, momentum, volatility, and value. Industry experts have yet to agree on not only the meaning, but also the metrics used to identify high-quality stocks.

“The aim of any quality measure should be to assist in estimating a company’s future profitability and the source of risk to which it is most subjected,” authors Daniel Ung, Priscilla Luk, and Xiaowei Kang said. 

“High-quality companies are seen as those that can keep a steady course in times of crisis by the fact that their earnings would generally be less sensitive to the volatility of the business cycle,” S&P Dow Jones Indices said.

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According to S&P, one could pinpoint high-quality companies using return-on-equity (ROE), balance sheet accruals ratio, and financial leverage.

The report argued that ROE was an effective measure of a company’s profitability. S&P data revealed companies with high ROE—measured by examining the company’s 12-month income scaled by book value—tend to perform well and were expected to remain profitable in the future.

The accruals ratio could be used to estimate a company’s stock returns across different markets, the report said, determining how earnings reflected the strength of a firm. It also emphasizes a company’s cash earnings, S&P contended.

And finally, the report said measuring financial leverage could help determine a company’s ability to reduce risk in times of market volatility.

“High-quality companies are seen as those that can keep a steady course in times of crisis by the fact that their earnings would generally be less sensitive to the volatility of the business cycle,” the authors said.

The report also found stocks valued as high-quality using these standards outperformed low-quality counterparts on an absolute and a risk-adjusted basis for a long period of time.

According to the firm’s data, from 2000 to 2013 S&P Quality Indices beat their market-cap weighted benchmarks. The outperformance was most staggering in the US, topping their benchmarks by 5.4%. They also displayed lower return volatility and lower maximum drawdowns than their benchmarks.

The S&P Quality Indices provided downside protection in bear markets—consistent with their good performance during slow economic growth—but fell slightly in bull markets. However, the report said the significant excess returns during bad times contributed to high-quality stocks’ outperformance over the long term.

Read the full paper here.

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