Factoring the Differences Between Quality and Value
When it comes to investing, most of us are familiar with the various “style boxes” popularized by Morningstar: Small, Medium and Large capitalizations paired up with Value, Blend and Growth equity attributes. There are a multitude of investment vehicles and options to provide investors exposure to any of the various different combinations.
Two of the categories, Value and Small Cap, are also identified as investment factors. An investment factor is a characteristic of a group of stocks that explain their risk and return. Value and Small Size, through rigorous academic research, have shown to contain measurable risk premium that can be extracted over time. Other factors, outside of the Morningstar Style Box, that have been identified to provide investors a return premium are Low Volatility, High Dividend Yield, Momentum and Quality. Similar to Value and Size, there are numerous active fund managers and ETFs that aim to capture one or more of these lesser-known factors as part of their investment mandate.
Fortunately, there are observable indexes that track these factors. Market-cap weighted indexes like the S&P 500 derive their allocations solely based on the size of the company. Factor-weighted indexes calculate portfolio holdings based on weighting one or more factors. Factor indexes can be either a subset of a larger price weighted index, or include all the components of a broad index with a weighting methodology other that price.
Some of the characteristics that determine the various factors are easy to measure: market capitalization, volatility, momentum, and dividend yield are all relatively easy to calculate. The Quality and Value factor, however, are more subjective. So what is the difference between the Value and Quality and how do index providers go about weighting these factors?
MSCI, a leading index provider, constructs indexes according the following criteria:
In both cases, the factor indexes include all the securities in a broad, price-weighted index (US MSCI Investable Market Index), re-weighted according to the above criteria. After the re-weighting, you end up with portfolios with very different sector exposures.
QUAL and VLUE are two ETFs that track the MSCI Quality and Value factors. The sector exposures for each ETF is shown in the table below:
The QUAL portfolio has a much higher weighting to the technology, consumer cyclical and health care sectors. These three sectors account for over 63% of all exposure in QUAL compared to 36% for VLUE. The financial and energy sectors dominate the VLUE allocation, accounting for 32.8% of the portfolio, compared to 11.8% in QUAL.
In summary, according to the value and quality factor screens performed by MSCI, high quality companies (those with low debt/equity ratios, high return on equity, and stable earnings) are mostly found in the technology, consumer cyclical and health care sectors. Companies that exhibit the most value (strong sales, high earnings, good cash flow and a low price to book ratio) are currently found in the financial services, technology and energy sectors. The value factor appears to be more equally distributed across the different sectors. In fact, QUAL does not have any companies at all in the real estate, utilities and communication services sectors, whereas VLUE has a combined weight in those sectors of 9.3%.
From a fundamental perspective, QUAL has a 5.76 Price/Book ratio compared to a 2.13 ratio for VLUE. The Price/Earnings ratio for QUAL is 20 versus 18.4 for VLUE. This makes intuitive sense given technology stocks (largest sector allocation in QUAL), generally trade at higher Price/Book ratios than financial companies (largest exposure in VLUE).
As you can see from the data, the Value and Quality factors are not similar at all. Re-weighting a broad index according to these factors provide very different results in terms of portfolio composition. Investors need to be aware of the sector tilts that are generated through over-weighting or under-weighting various factors. Using factors to gain exposure to a certain type of company can be an excellent way to diversify away from traditional market-cap weighted indexes, but you may be increasing your concentration and exposure to a narrower group of industries and sectors. Expressing a view on a factor may come with other undesirable risks.