An Appropriate Time to Make a Quality Query

Of the five major investment factors – low volatility, momentum, quality, size and value – quality is perhaps the most overlooked. One reason for quality's overlooked status could be the multiple ways in which investors define the factor. No other factor creates a variety of definitions and opinions on par with quality.“It’s likely the factor where opinions are most diverse regarding the definition,” according to Factor Research . “Broadly speaking there are qualitative and quantitative evaluations and these are often combined in a scoring model. Criteria like management quality or the soundness of strategy are intuitively appealing, but difficult to verify given a lack of data.”At the index level, various benchmarks that isolate the quality factor go about that endeavor in varying fashion. For example, the JP Morgan US Quality Factor Index starts with the Russell 1000 universe , whittling that space down based on quality and profitability characteristics while targeting high-quality equities and minimizing stock-specific risk.Conversely, the MSCI USA Sector Neutral Quality Index takes into employs return on equity (ROE), low leverage and low earnings variability in its weighting methodology. More variables or increased complexity in application of the quality factor do not always leader to superior results. Since December 2017, its first full month of trading, the JPMorgan U.S. Quality Factor ETF ( JQUA ), which tracks the JP Morgan US Quality Factor Index, is beating the MSCI USA Sector Neutral Quality Index by more than 300 basis points. When Quality Works As has been widely documented , the primary limitation of single-factor approaches is that factor leadership is fluid. Put simply, the best-performing factor this year could be a laggard next year. That said, history indicates there are environments in which certain factors repeatedly outperform others. In the case of quality, that factor often performs well in slowing or contracting economies or when volatility is increasing.Related:Related:Factors can deviate from historical trends and quality is no exception. The U.S. economy is neither contracting nor slowing. Nor is equity market volatility unusually high this year, but JQUA is up nearly 10% year-to-date (as of Sept. 21, 2018).

There is also a perceived intersection of the quality and value factors.

“Quality can even be viewed as an alternative implementation of value—buying high quality assets without paying premium prices is just as much value investing as buying average quality assets at a discount,” according to the “ Quality Investing” research by Robert Novy-Marx.While there are some implementation similarities between quality and value, historical data suggest quality stocks often command premium valuations. That says investors, in certain market climates, are willing to pay up for high ROE, low debt-to-equity ratios and predictable earnings rather than embracing what appears to be a good deal (value).There are also large performance gaps in dedicated quality and value strategies. Since Dec. 1, 2017, JQUA has outperformed the S&P 500 Value Index by a margin of more than 2-to-1. Other Hallmarks Of QualityOne consistent hallmark of quality companies is a strong balance sheet. At the end of last year, there were 17 U.S. companies with a combined $800 billion in cash on hand. Six of those 17 companies, including Apple Inc. (AAPL) and Alphabet Inc. (GOOGL), are among JQUA's top 10 holdings.Thanks in part to the tax reform legislation passed late last year, U.S. companies could repurchase a whopping $1 trillionof their own shares this year. In the second quarter alone, U.S. firms repurchased a record $433.6 billion of their own stock. The technology sector, JQUA's largest sector allocation at 20.70%, is one of the most voracious buyers of its own stock.There can also be an income component to the quality factor. Seven JQUA's top 10 holdings are dividend payers. Some of JQUA's holdings, such as Johnson & Johnson (JNJ), have some of the longest dividend increase streaks in Corporate America. Others, including Apple and Microsoft Corp. (MSFT), are more recent but undoubtedly impressive dividend raisers. With a 9.50% increase earlier this month, Microsoft's quarterly dividend has doubled over the past five years. The stock is JQUA's third-largest holding.