Friday, February 18, 2022

Quality factor variables as diverse proxies

 


Looking beyond value risk factor requires more digging into financial accounting. The quality factor is a unique alternative to value and provides another effective way to sort firm, but it comes at a price of more work and interpretation.

There has been significant work to extend the 3-factor Fama-French (value, size, market risk) framework to broader 5-factor and 6-factor frameworks that adds (profitability, investment, and momentum). Others have tested and employed momentum, quality, and volatility as additional core risk factors. We have discussed how different factors have different degrees of complexity, see "Which investment factors are hard to measure? Risk factor measurement as art"

Quality is one of the more difficult factors to measure because it has several characteristics used for its description: profitability, financial strength, and stability. Hence, quality is harder to measure than a simple factor like momentum, volatility, or market risk. The proxies or ratios employed to describe quality include profitability, ROE, ROA, net income, asset growth, payout ratio, debt to equity, and sustainable growth. These are measured for current data or for some rolling average period like five years. 

In all cases, since there is not clear agreement on what is quality, there can be different sorts for any set of stocks and different return results when the quality risk factor effect is presented. While the quality factor is a way to "split the difference" between value and growth, there is significant room for interpretation on this risk factor. Nonetheless, the quality factors needs to be explored more deeply as a way to breakout of the value/growth discussion.


No comments: