Many investment factors are straight-forward and easy to comprehend. For example, growth stocks offer prodigious rates of earnings and sales growth, and usually trade at multiples that reflect as much.
Conversely, value stocks are those trading below book value or at attractive price-to-earnings ratios, among other metrics. However, quality is fluid when compared to the other factors. As such, it may be the most heavily-debated factor in the financial community.
What’s not up for debate is the need to be on the same page in understanding quality’s long-term durability. Jeff Weniger, WisdomTree head of equity strategy, brings some much-needed clarity to the quality conversation by focusing on profitability gauges.
“The oft-cited profitability metric is return on equity (ROE), while the debt part is sometimes found by checking how the company stacks up in the context of return on assets (ROA),” he said in a recent report. “If ROA is low and ROE is high, we know how the firm achieves it: management gooses the balance sheet with debt. You can minimize the goosing by explicitly incorporating ROA into a smart beta screen.”
Real-Time Quality Applications
For advisors looking to put quality into practice – meaning into client portfolios – without the burden of selecting individual stocks, WisdomTree offers an array of exchange traded funds that embrace quality in significant fashion.
That job is made even easier with the issuer’s expansive lineup of model portfolios that focus on quality, with the WisdomTree Global Dividend Model Portfolio being a prime example. There’s more good news for advisors and clients: quality is currently on sale.
“Not only that, but quality has been lagging in this 15+ month market moon shoot. Sure, you could have bigger problems in life than watching the S&P 500 Quality index go up “only” 95.6% since March 23, 2020. Nevertheless, that is 4 percentage points short of the 99.7% run in the S&P 500 off the COVID-19 lows,” adds Weniger. “It’s showing up in valuations. According to Bank of America’s quant team, we have not seen high quality stocks this cheap relative to low quality peers in over a decade.”
Additionally, it’s a good time to consider quality because the economic cycle could be on the cusp of turning away from rewarding junky value fare.
“Though low quality has been running higher as the COVID-19-inspired economic depression transitioned to early recovery, one of these days we will enter the middle of the economic cycle—if that stage is not already here,” concludes Weniger. “The impulse to buy anything and everything, with little regard for operational efficiency, should seemingly fade as the clock ticks. That environment would enable quality concepts to claw out of this tunnel of frustration.”
For more on how to implement model portfolios, visit our Model Portfolio Channel.