TERADAT SANTIVIVUT
By Ryan Giannotto, CFA, Manager Equity Index Research
We are all familiar with the reputation for fine thread counts and exquisite craftmanship of haute couture brands like Armani, but we also know that such quality commands a premium, and buying a small number of quality items can be expensive. Conversely, we all know the value trap of bargain brands: – sure the clothing is cheap, but at what cost? Once they have been through a few cycles, they may fall apart.
Equities are intangible – and lack the je ne sais quoi of a fine Italian suit – but the same trade-off between value and quality applies. Excesses in both the directions of quality and value can prove suboptimal from an investment perspective. A fixed tilt to quality produces a Price to Sales ratio 2.3 times higher than a tilt of equivalent strength into value – is there a way to achieve quality at a reasonable price (i.e., sans the limited-edition valuations)? Could there be an equity strategy which fulfills this mandate of uncovering the metaphorical Armani in the large-cap universe.
Factor Bending: Quality as a Science
Much as in the world of fashion, quality and value are negatively correlated factors in a financial setting as well. The logic is intuitive, but the results are quite powerful as showcased in the Russell 1000 Qual2/Val Index, which leverages the anti-correlative properties of these factors. Since 2010, the excess returns of quality and value, as described by the FTSE Russell Global Fixed Tilt Index Series, realized a daily correlation of -0.588.
So consistent is this relationship that tilting into either quality or value will generally produce negative exposure to the other factor – an unintended bet that requires active correction. The Russell 1000 Qual2/Val Index, however, extends this factor neutralization process yet further with direct bets on the oppositional factor. Conceptually, the methodology forces together the disparate circles of a Venn Diagram to exploit the resultant overlap.
What characteristics define the oppositional factors of quality and value? FTSE Russell takes a comprehensive view to factor construction, believing that a multidimensional analysis best captures the nuances of factor behavior throughout market cycles. In the case of value, stocks are evaluated on their earnings yield, cash flow yield, and sales to price ratio, with each measure given a one-third weight. For quality, companies are assessed equally in terms of their leverage (cash flow coverage ratio) and their profitability, which in turn examines Return on Assets (ROA), change in turnover, and accruals.
Each of the base metrics is measured by z-score, or the number of standard deviations each company falls from the average, capped on a range of plus or minus three. These scores are then renormalized by the Gaussian error function to produce results in the range of zero to one, to which the factor tilt powers are applied as an exponent. In sum, this process generates the scalars for quality and value that are directly multiplied against market cap weights to create the new factor tilt portfolio. The Russell 1000 Qual2/Val Index raises quality scores to the second power and value to the first – the emphasis is finding Armani on sale, not quality at the bargain store. Another important consideration is that the value and quality tilts are not two separate screens, but rather they work in conjunction with each other as a unified methodology.
Quality Performance, Discount Pricing
This hybridization of competing factors begets a compelling narrative in terms of performance. Indeed, the 2-1 factor tilt strategy achieves an outcome where quality and value each compensate for the other’s weaknesses as factors cycle in favorability.
The period since December 2013 exemplifies these characteristics in two clear phases of performance behavior. Foremost, in the timeframe from January 2017 to August 2020 specifically, value declined 21.4 percentage points on a relative basis to the benchmark, while the Russell 1000 Qual2/Val Index staved off 88.5% of this downdraw. Decidedly is a novel concept, a value-oriented strategy that not only remained market competitive but outperformed by 30% through the 2010s!
After August 2020, however, as quality’s relative performance advantage recessed, the Russell 1000 Qual2/Val Index still advanced 9.19 percentage points on a relative basis through March 2023 as value rebounded. Extending the analysis back to December 2001, the 22-year history further corroborates the merits of melding these counteracting factors, both on an absolute and risk-adjusted returns basis. Specifically, the Russell 1000 Qual2/Val Index exhibited 28.0% greater risk efficiency than the benchmark and 15.5% and 7.4% than either value or quality indices individually.
The narrative of anti-correlation further enrichens when examining portfolio fundamentals, as the quality index generally rates poorly on value metrics (i.e., more expensive), and value likewise disappoints by quality standards (i.e., more indebted, less profitable). For instance, quality achieves a ROA 109% higher than the value index can manage, while value attains a cash flow yield 81% greater than that for quality. The disparities are stark.
What is striking about the Russell 1000 Qual2/Val approach, however, is it proves the desired fundamentals for quality and value are not mutually exclusive; indeed the strategy moves in both directions simultaneously. Notably, the strategy secures core quality characteristics – improving cash flow coverage by 7.4 basis points and enhancing ROA by 12% – all while exhibiting better than benchmark pricing. Although it may not necessarily improve your wardrobe, finding quality in the market without overpaying does capture the magic of Armani on sale.
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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
