International | Sep 30 2021
Research by The Leuthold Group suggests better returns await those investors who combine cheaper asset prices ('Value') with a Quality assessment.
Q’Val: A Factor Powerhouse
By Scott Opsal, The Leuthold Group
Quant researchers widely agree that Value offers a return premium over time (although not recently) and that High Quality also offers excess returns.
The Quality angle seems contrary to intuition, in that investors generally prefer Quality companies and are willing to pay up for them, yet Quality regularly outperforms. Value and Quality are both well-respected investment factors, and we were curious to explore the interaction of these two smart beta stalwarts.
Is Value enhanced by adding a layer of Quality, thereby avoiding value traps, or are Value investors better off buying junky, unattractive companies that have the most room to rebound from depressed prices?
Our study measures the interaction of Value and Quality using a two-stage methodology. First, we quin-tile companies based on the Value factor and focus on the cheapest basket. Second, we divide the cheap-est Value basket into the 40% of companies with higher Quality ratings (Quality Value or Q’Val), and the 60% of companies with lower Quality ratings (Junky Value or J’Val).
The Quality and Value signals in this study are proprietary multi-factor models employed in our own portfolio management processes.
Again, our objective is to determine whether Value investors are better off tilting toward Quality companies, or if owning the junkiest companies offer the best bargain opportunities.
We begin with an analysis of the basic Value factor using the cap-weighted S&P 500 universe from 12/31/1996 through 8/31/2021. Chart 1 plots the return spread between the cheapest and most expensive S&P 500 quintiles, rebalanced monthly.
It paints the familiar story of Value’s outperformance up to the Global Financial Crisis, followed by a sideways decade and the recent drop caused by the outperformance of Social/Mobile/Cloud growth companies. While conventional Value signals that rely on price to book peaked in late 2006, multi-factor Value metrics based on other well-regarded ratios only succumbed to the mega-cap growth boom in 2017.
This study focuses on the “best value” sleeve comprised of the cheapest quintile of companies. Our next step is to separate the cheapest Value stocks into two Quality sleeves to determine which, if either, provides an extra boost to the Value factor’s excess returns over the long run.
Chart 2 begins with the best Value quintile’s 11.8% annualized return, then adds the returns for the Quality and Junky sleeves of the cheapest Value companies. On a long-short factor basis, Q’Val outperformed J’Val by 1.5% annually. Even on a long-only basis, it added another 0.4% on top of the return from the Value style itself.