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The quality factor refers to the tendency of high-quality stocks with typically more stable earnings, stronger balance sheets and higher margins to outperform low-quality stocks, over a long time horizon.
The outperformance of high-quality stocks over low-quality stocks is well-documented in financial literature although the actual measure of “quality” is disputed. Metrics such as a company’s earnings, dividend payments and debt levels have all been shown to have as much explanatory power in relation to a stock’s performance as the value factor.
Quality-based strategies try to capture the premium associated with high-quality stocks versus low-quality stocks. However, of all the risk factors, this is perhaps the hardest to define as investors are divided on the best way to measure quality.
Depending on the investment manager, quality can mean gross profitability, return on invested capital, growth, stability of earnings, high payout rates, or low volatility and fundamental risk. Regardless of the metric, strategies that attempt to target quality typically outperform the market, as they are better equipped to weather adverse economic conditions.
The quality factor remains something of an enigma for factor investors and academics alike, since higher-quality stocks intuitively should come with higher prices. The fact that quality is not fully priced into the stock, perhaps due to inadequate risk models or behavioural biases, may go some way to explaining the existence of the premia.
See also Factor investing.