How Firms With Strong Fundamentals (quality stocks) Perform Compared To Others

Performance of Quality Stocks Estimator

Introduction

I just finished reading a really insightful academic paper from the IIM, Ahmedabad titled “Performance of quality factor in Indian Equity Market”. It’s a working paper from November 2022, authored by Joshy Jacob, Pradeep K.P., and Jayanth R. Varma.

I always looking for ways to understand our markets better. This paper caught my eye and I though to read it patiently in my spare time.

As I went through it, I thought, “This is something many of us would want to know about.” So, I thoght why blog about this topic (again), in IIMA’s style.

Suggested Reading (my other posts on a similar topic):

• Stock Quality Checklist Tool for Long-Term Investing
• How To Identify Good Stocks: Explained For Beginners
• Finding Undervalued Growth & Quality Stocks With Stock Engine’s Big Screener

So let’s take a deep dive into what IIMA has to say about quality stocks.

1. About The Quality Factor

In stock market investing, we often hear about different “factors” that drive returns. We hear things like:

• Size: How big or small is a company,
• Value: Whether its stock is cheap or expensive, or
• Momentum: If it’s been performing well recently.

But there’s another factor, perhaps less talked about among everyday investors that we must know about. In today’s stock investing environment, where there are more traders than investors, this factor is increasingly becoming more important.

I’m talking about Quality.

The IIMA paper specifically talks about something called the “Quality Minus Junk” (QMJ) factor. This phrase was first published by the Yale Department of Economics in 2013.

I found this expression very welcoming. This was the reason why I was drawn towars this paper.

What is QMJ factor?

It talks about investing in high-quality stocks and simultaneously betting against (or shorting) low-quality stocks.

This idea has been around for a long time, with investors favouring high-quality stocks. But this academic paper gave a proper term to it. I like it.

So, what makes a company “high quality” then?

Well, that’s what the IIMA paper really dives into for our Indian market. In this blog post, I’ll highlight the points covered in the paper related to high quality companies.

2. Why Quality Matters Even More in India

Investing in an emerging market like India is where quality of companies matters the most.

Because more often than not we (retail investors) end up owning low quality stocks. There are more junk stocks in our market than quality ones.

India is the second-largest emerging market globally, with a market capitalization of nearly Rs.3.7 trillion.

But the hypotesis is this (again), quality factor is more important for asset pricing in India than in developed markets. Why? Here are a few pointed facts:

• Firstly, the paper points out that enforcement of corporate governance norms has historically been weaker in emerging markets (like India). Does that ring a bell? We’ve all heard stories. For example, ICICI Bank and Vodafone loan recovery controversy of 2016-18 (read about it here).
• Secondly, family-owned business groups are a huge part of our economy. They can sometimes bring unique governance problems. Read about the 2009 case of Satyam Computers then run by its founder and charman Ramalinga Raju.

These issues can lead to promoters (controlling shareholders) diverting revenues, resulting in poor profitability, or tunneling profits.

How does these governance issues effect the stock? It leans to lower payouts and slower growth for the company.

Hence, I think, investors here (in our country like India) should attach greater significance to quality dimensions when pricing stocks.

3. How Do You Measure “Quality” Anyway?

We can’t just have a just a vague feeling about a good company (quality) and think it as a buy stock.

The academic paper follows a very specific methodology to define and measure quality.

They compute a quality score for each stock by averaging its ranking across four key financial dimensions:

• Profitability: This looks at how well a company generates profit from its assets. Think about gross profit over assets (GPOA), return on equity (ROE), return on assets (ROA), cash flow over assets (CFOA), gross margin (GMAR), and accruals (ACC). A profitable company is usually a good sign.
• Growth: This dimension focuses on the company’s growth over five years. It’s about the growth in profitability metrics like gross profit over assets, return on equity, return on assets, cash flow over assets, and gross margin. Healthy growth indicates a thriving business.
• Safety: This is about how stable and low-risk the company’s operating performance is. It includes factors like low beta (meaning less volatile than the market), low leverage (less debt), low bankruptcy risk (using scores like Ohlson’s O-Score and Altman’s Z-Score), and low volatility in ROE.
• Payout: Here the focus is on the level of reinvestment needed for future growth. It looks at net equity issuance, net debt issuance, and the total net payout over profits. Firms that exhibit lower net equity and debt issuance are considered higher quality as they demonstrate less reliance on external capital. A higher total net payout over profits signifies that the company generates sufficient earnings and efficiently manages its capital, requiring less internal reinvestment for growth.

The overall quality score is a simple average of these four dimensions. Even my Stock Engine uses a similar algorithm to give an overall score to its stocks.

Based on the ‘overall quality score’, the paper define “quality stocks.”

• Those stocks which are in the top 10% of quality score are labelled as quality stocks.
• Similarly “junk stocks” as those in the bottom 10%.

As per the QMJ factor, the investors will take a long position in quality stocks (both small and big caps) and a short position in junk stocks (small and big caps).

The paper also highlights a think called “long-only” quality factor (LQ). What does this mean? It simply means investing only in the high-quality stocks.

The academic papaer covered Indian stock data from April 1995 to March 2021. They focused on the top 1,000 firms by market capitalization. They had a supplementary analysis on top-500 and top-250 firms.

4. The Power of Quality

The findings are quite compelling and make a strong case for integrating quality into our investment decisions:

4.1 Exceptional Returns (Alpha)

This is perhaps the best takeaway of investing in quality stocks.

The QMJ factor earned a four-factor alpha of 0.92% per month.

What does it mean? It mean, QMJ investment strategy, which involves being long high-quality stocks and short low-quality stocks, achieved an excess return of 0.92% per month over the market’s averaged returns.

The 0.92% per month (a positive alpha) indicates that the quality factor in India has delivered superior returns.

To put that in perspective, this monthly alpha of Indian is nearly 50% higher than what’s observed in the US market.

Even a long-only Quality factor (LQ) delivered a significant alpha of 0.69% per month.

The key drivers of this alpha, according to the study, are profitability and payout.

4.2 Better Risk Management (Lower Drawdowns)

One of the biggest fears in investing is seeing your portfolio drop significantly and take ages to recover. This is called a “drawdown.”

The IIM’s academic papaer found that quality portfolios have significantly better drawdown characteristics than other factors.

For instance, the maximum drawdown period for the QMJ factor was about 78.57 weeks.

It is noticeably faster recovery compared to the momentum factor’s 600 weeks.

The average and worst drawdowns were also lower for quality portfolios.

What does it mean? It means, our investments in quality stocks are likely to experience smaller and quicker recoveries from market dips.

As an investor, this is a huge psychological and practical advantage when I’m picking stock for long term holdings.

4.3 Less Portfolio Churn (Lower Transaction Costs)

Frequently buying and selling stocks due to factor changes (like say a volatile Overall Score) can eat into your returns due to transaction costs.

The good news here is that quality factor rankings of stocks are “sticky,” meaning they don’t change very often.

This is very reasonable. Why/ Because quality is based on fundamental company data, not volatile market prices.

The study found that the average annual churn rate for the quality factor was only about 87%. Meanwhile, for momentum, it was 249%.

This means lower trading costs, allowing more of the alpha to stay in your pocket.

4.4 Works Even for Large-Cap Stocks

It’s often believed that unusually good investment returns (called “anomalies”) are only found in smaller companies. You must have heard pro investors investing in mid-caps and small-cap stocks for very high long term returns.

But investing in these small stocks can be tricky and costly to take advantage of because of higher trading expenses.

However, the IIMA study specifically investigated the “quality factor” in India’s largest companies. The looked at at the top 500 firms by market value.

They discovered that even among these big companies, investing in quality stocks (both by buying high-quality and selling low-quality, or just buying high-quality) still produced significant “alpha. ”

It means, even these large stocks returns better than what normal market movements would explain.

This shows that the “quality factor” strategy is practical and has “high investment capacity,” making it a great option for even very large investors like institutions

4.5 Quality Commands a Price Premium

The study also explored whether quality stocks are valued higher by the market.

They found that, indeed, stocks with high quality scores command a price premium in the Indian market.

A one-standard-deviation increase in a stock’s quality score led to a 23.6% increase in its market-to-book premium over the entire sample period.

This tells us that the market recognizes and rewards quality.

Conclusion

The IIMA paper paints a very encouraging picture for the quality factor in the Indian equity market.

It strongly suggests that focusing on high-quality companies, as defined by their profitability, growth, safety, and payout characteristics, can lead to economically and statistically significant monthly alphas.

We’re talking about an annualized four-factor alpha of over 10% for the long-short quality factor, which is quite something.

What does it mean? The “long-short quality factor” strategy, where you buy high-quality stocks and simultaneously bet against low-quality ones, achieved an average annual return of over 10%. This “alpha” represents pure, exceptional profit.

Beyond just the returns, the favorable drawdown features and the persistent nature of stock-level quality scores make it incredibly practical.

You get a better risk-reward ratio, and you don’t need to constantly churn your portfolio often

Investors looking to make smarter investment decisions in the Indian market, this research offers a compelling reason to consider tilting our portfolios towards quality stocks.

Have a happy investing.