Quality Factor

The quality factor in finance refers to a specific strategy within the “factor investing” philosophy that focuses on companies with high-quality characteristics. 

These characteristics typically include strong profitability, a strong balance sheet (high-quality assets in excess of liabilities), and efficient management. 

The quality factor approach assumes that companies with these attributes are more likely to outperform the market in the long run, even during economic downturns.

Key Takeaways – Quality Factor

• What Is it? The quality factor in finance is a market strategy that focuses on companies with strong profitability, solid financial health, and sound management.
  • It aims to identify businesses likely to deliver sustainable, long-term market outperformance.
• Profitability Drives Quality – Look for high ROE (>15%), ROA (>5%), and ROIC exceeding the cost of capital, paired with gross profit margins above industry averages.
• Financial Health is Essential – Companies with low leverage (debt-to-equity < 0.5) and strong liquidity (current ratio > 1.5) demonstrate resilience, particularly during downturns.
• Management Efficiency Counts – High asset turnover (>1), inventory turnover above peers, and low Days Sales Outstanding (<30 days) signal effective operations.
• Valuation Reflects Quality – Premium P/E, P/B, and P/S ratios often align with sustainable growth and strong competitive advantages, like economic moats.
• For Day Traders? The quality factor, typically seen as a long-term principle, is relevant to short-term traders because high-quality stocks with strong profitability, financial health, and management efficiency offer price stability, lower volatility, and resilience against macro-/sentiment-driven fluctuations.
  • This makes them less prone to extreme drawdowns and better positioned to respond to positive catalysts.
• ETFs – We give example quality factor ETFs.
• Example Criteria – We give example specific quality factor criteria at the end of this article that could be used as part of a screen or checklist for a discretionary trader or as part of the setup for a systematic trader trading algorithmically.

Profitability

Return on Equity (ROE)

Measures how effectively a company uses its shareholders’ investments to generate profits.

A high ROE indicates that the company is generating a good return on the money invested by its shareholders.

Return on Assets (ROA)

Measures how efficiently a company uses its assets to generate profits.

A high ROA indicates that the company is effectively using its assets to generate earnings.

Return on Invested Capital (ROIC)

Captures the returns on all invested capital.

Gross Profit Margin

Measures the profitability of a company’s core business activity.

It’s calculated as revenue minus the cost of goods sold, divided by revenue.

A high gross profit margin indicates that the company is effectively managing its production costs and pricing its products or services.

Financial Health

Liquidity

Measures a company’s ability to meet its short-term obligations.

It’s typically evaluated using metrics like the current ratio and the quick ratio.

Leverage

Refers to the amount of debt a company uses to finance its operations.

High leverage can increase a company’s risk, as it must make mandatory payments on its debt regardless of its profitability.

Leverage can be looked at using metrics like the debt-to-equity ratio and the debt-to-asset ratio.

Solvency

Refers to a company’s ability to meet its long-term obligations.

It’s a measure of its long-term financial viability.

Management Efficiency

Asset Turnover

Measures how efficiently a company uses its assets to generate sales.

A high asset turnover ratio indicates that the company is effectively using its assets to generate revenue.

Inventory Turnover

Measures how quickly a company sells its inventory.

A high inventory turnover ratio indicates that the company is effectively managing its inventory and avoiding the accumulation of obsolete or slow-moving items.

Days Sales Outstanding (DSO)

Measures how long it takes a company to collect payment from its customers.

A low DSO indicates that the company is effectively managing its credit and collections process.

Quality Factor in Valuation

Investors are willing to pay a premium for companies with high-quality characteristics because they’re perceived as less risky and more likely to generate sustainable profits.

This premium is reflected in higher valuation multiples, such as:

Price-to-Earnings (P/E) Ratio

Compares a company’s market price per share to its earnings per share.

A high P/E ratio indicates that investors are willing to pay a premium for each dollar of earnings.

Price-to-Book (P/B) Ratio

Compares a company’s market price per share to its book value per share.

A high P/B ratio suggests that investors are willing to pay a premium for the company’s net assets.

Price-to-Sales (P/S) Ratio

Compares a company’s market price per share to its annual revenue per share.

It’s often used to value companies that aren’t yet profitable.

Quality Factor in Security Selection

Quantitative Factors

Include metrics such as profitability, financial health, and management efficiency.

These metrics are used to screen for companies that meet quality criteria.

Systematic traders turn their ideas into algorithms, which eventually go into production to be used in live trading environments.

Qualitative Factors

Include the company’s competitive position, its management team, and its corporate governance.

These factors are more subjective but provide insight into the long-term prospects of a company.

Many traders/investors nonetheless do try to quantify these in the best way possible.

Training on Quality Factor

When trading and investment firms consider the quality factor and how they’ll use it, they’ll have the following considerations:

Understanding the Concept of Quality

Defining high-quality companies and the metrics used to assess quality.

Understanding the relationship between quality and asset performance.

Identifying Quality Companies

Using quantitative and qualitative factors to screen for companies with high-quality characteristics.

Considering the limitations of different metrics and the importance of industry context.

Incorporating Quality into Market Strategies

Learning to integrate the quality factor into various strategic approaches, such as value investing, growth investing, and factor investing.

Understanding the role of quality in portfolio construction and risk management.

Applications of Quality Factor in Different Asset Classes

Exploring how the quality factor applies to different asset classes, including equities, fixed income, and real estate, and the specific metrics relevant to each.

Quality Factor for Day Traders

Even though the quality factor is often seen as a longer-term investment principle, it remains relevant to short-term traders due to its influence on price stability and market dynamics.

Broader market movements – i.e., driven by factors like growth expectations, inflation, interest rates, and risk premiums – often dominate short-term price changes, the strength of a company’s profitability, financial health, and management efficiency (key aspects of the quality factor) provide an important foundation for valuation.

For example, a stock with a high ROE and strong financial health consistently generates earnings and cash flow, which serve as an anchor for its valuation even in volatile markets. 

Suppose a stock is priced with a P/E ratio of 20 (valuing the company at 20 times its annual earnings). 

On a quarterly basis, this reflects approximately 1/80th, or 1.25%, of its market value accruing to the company every three months.

This may seem modest, but the steady contributions from earnings or efficient operations can still reinforce the stock’s value amid shifts in the other variables we mentioned. 

Stocks that don’t have this kind of foundation generally have more volatility due to structurally longer duration.

Quality companies often maintain lower risk profiles, with strong fundamentals helping to offset the effects of external factors like rising discount rates or increased volatility.

For short-term traders, this stability can be a factor in their approach. 

High-quality stocks are less likely to experience extreme drawdowns. 

Additionally, models that incorporate the quality factor – such as by screening for companies with high ROE, low leverage, and efficient asset use – help identify stocks better positioned to withstand short-term pressures and react favorably to positive catalysts.

Accordingly, while the quality factor generally shines over the long term, its relevance to short-term trading lies in its ability to stabilize valuations and provide a consistent baseline for price action despite short-term macro or sentiment-driven fluctuations.

Research on the Quality Factor

We look at two papers involving the quality factor:

• How to Improve Quality Investing
• Revisiting Quality Investing

Defining “Quality”

First, there’s the lack of consensus around what constitutes a “quality” company. 

Unlike value investing or the value factor, which relies on clear metrics like the price-to-book ratio, quality is inherently more subjective. 

To tackle this, the research proposes a multi-dimensional framework for defining quality, centered on four pillars:

1. Profitability – Classic measures such as Return on Invested Capital (ROIC), gross profitability, and Piotroski’s F-Score are used to assess a company’s ability to generate strong, consistent returns.
2. Earnings Quality – Focuses on the stability and sustainability of earnings, emphasizing consistent growth and low earnings manipulation.
3. Safety – Examines financial health and stability, incorporating metrics like low debt, low beta (volatility), and strong credit ratings.
4. Investment – Highlights the efficiency of capital allocation by management, including metrics such as R&D spending relative to sales and effective reinvestment of profits.

Performance and Key Drivers

They found that a well-defined, multi-dimensional quality factor generates significant alpha — returns above the market benchmark — even after accounting for other factors such as size, value, and momentum.

Notably, the “safety” dimension proves effective during market downturns, such as the 2008 financial crisis and the COVID-19 pandemic, reinforcing the defensive nature of quality companies.

Regional Differences and Portfolio Construction

The study identifies regional variations in the performance of the quality factor.

For example, challenges in the Eurozone suggest the need for a sector-neutral approach to portfolio construction, likely due to sector-specific risks and economic factors in the region.

Economic Moat and ESG Integration

The concept of the “economic moat,” popularized by Warren Buffett, is incorporated.

An economic moat represents a company’s sustainable competitive advantage, allowing it to maintain high profitability over time.

The research finds that combining quality with a wide or narrow moat enhances performance, highlighting competitive advantage as a critical element of quality.

Measuring an economic moat involves qualitative assessments of these factors and quantitative metrics such as consistently high ROIC, stable or growing market share, and strong pricing power. 

Analysis techniques like Porter’s Five Forces framework and financial ratios, such as gross margins and operating margins, help analyze how effectively a company maintains its competitive edge over time.

The study also examines the role of ESG factors.

They found that adding high ESG scores to a quality strategy doesn’t always improve returns and may even result in an “ESG premium” (lower returns).

Nevertheless, combining high ESG scores with quality and a strong economic moat reduces this premium and can lead to better performance.

Analyst Opinions and QARP (Quality at a Reasonable Price)

The role of analyst opinions is explored, particularly in identifying undervalued quality companies.

The study suggests that incorporating metrics such as the average price-to-price target (based on analyst consensus) can enhance the performance of quality strategies.

This indicates that markets may not immediately recognize the value of quality companies, and analyst forecasts can help shed light into those with greater future potential.

The quality of sell-side research is nonetheless often debated, given the banking relationships they often have (or want to have) with the companies covered.

Quality Factor ETFs

Let’s look at some common quality factor ETFs.

We look at:

• what they track (what index)
• focus (what exposure do they provide, such as geography and market capitalization)
• AUM (the amount of assets under management)
• expense ratio (how much it costs – e.g., an expense ratio of 0.20% means a $20 annual cost for every $10,000 invested)

iShares MSCI USA Quality Factor ETF (QUAL)

• Tracks – MSCI USA Quality Index
• Focus – Large- and mid-cap US companies with high ROE, stable earnings growth, and low financial leverage
• AUM – Relatively large, making it highly liquid
• Expense Ratio – Reasonable, typical for a factor ETF

Invesco S&P 500 Quality ETF (SPHQ)

• Tracks – S&P 500 Quality Index
• Focus – S&P 500 companies with strong quality scores based on ROE, accruals ratio (earnings quality), and financial leverage
• AUM – Significant, providing good liquidity
• Expense Ratio – Similar to QUAL

iShares MSCI Intl Quality Factor ETF (IQLT)

• Tracks – MSCI World ex USA Quality Index
• Focus – International companies (excluding the US) with high quality characteristics
• AUM – Decent size, but less than the US-focused ETFs
• Expense Ratio – Slightly higher due to international holdings

JPMorgan US Quality Factor ETF (JQUA)

• Tracks – JPMorgan US Quality Factor Index
• Focus – US companies with strong operational, earnings, and balance sheet quality
• AUM – Moderately sized
• Expense Ratio – Competitive

FlexShares Quality Dividend Index Fund (QDF)

• Tracks – Northern Trust Quality Dividend Index
• Focus – Companies with high quality and dividend-paying characteristics
• AUM – Smaller than the top ETFs on this list
• Expense Ratio – A bit higher, but includes a dividend focus, so this is normal

VictoryShares Free Cash Flow ETF (VFLO)

• Tracks – Nasdaq Victory US Large Cap Free Cash Flow Index
• Focus – Large-cap US companies with strong free cash flow generation
• AUM – Relatively new and smaller
• Expense Ratio – Higher, reflecting a more niche focus

Vanguard US Quality Factor ETF (VFQY)

• Tracks – Russell 1000 Value Index
• Focus – Large-cap US companies with quality characteristics
• AUM – Large, as expected from Vanguard
• Expense Ratio – Very low, typical for Vanguard ETFs

Important Notes

• Expense Ratios – These can eat into your returns over time, so pay attention!
• Underlying Indexes – Each ETF tracks a different index, leading to variations in holdings and performance
• Trading Volume – Higher volume generally means it’s easier to buy and sell shares without affecting the price too much
• Objectives – Make sure the ETF’s objectives align with your own

Always research each ETF thoroughly before investing. Look at their holdings, performance history, and expense ratios to ensure they fit your needs.

Criteria for Defining and Measuring Quality in Investing

So… let’s nail down some criteria to make this more concrete.

To define and measure quality in a way that traders/investors can use, the following quantifiable and actionable criteria can be applied:

1. Profitability

• Return on Equity (ROE) – Greater than 15% indicates strong utilization of shareholders’ investments to generate profit.
• Return on Assets (ROA) – Greater than 5% suggests efficient asset utilization.
• Return on Invested Capital (ROIC) – Exceeds the company’s cost of capital, indicating efficient investment of resources.
• Gross Profit Margin – Higher than industry average shows effective cost management and pricing strategy.

2. Financial Health

Liquidity

• Current Ratio (Current Assets / Current Liabilities) – Greater than 1.5.
• Quick Ratio (Quick Assets / Current Liabilities) – Greater than 1.0.

Leverage

• Debt-to-Equity Ratio – Below 0.5 indicates manageable debt levels.
• Debt-to-Asset Ratio – Less than 40% shows a strong financial base.

Solvency

Consistent ability to meet long-term obligations, indicated by an interest coverage ratio above 5.

3. Management Efficiency

• Asset Turnover – Higher than 1.0 suggests assets are effectively generating revenue.
• Inventory Turnover – Exceeds industry average, showing efficient inventory management.
• Days Sales Outstanding (DSO) – Less than 30 days indicates strong credit and collections processes.

4. Valuation Metrics

• Price-to-Earnings (P/E) Ratio – Compare to industry benchmarks. High ratios may reflect premium quality. Factor in the company’s growth rate, as higher growth companies are typically given higher P/E’s. Consider the PEG ratio.
• Price-to-Book (P/B) Ratio – Greater than 1.0 shows investor confidence in the company’s net assets.
• Price-to-Sales (P/S) Ratio – Assess relative to peers, with higher values for stable revenue growth. May not be relevant.

5. Earnings Quality

• Stable or growing earnings over 5+ years.
• Low earnings manipulation risk, using metrics like Beneish M-Score or accrual ratios.

6. Economic Moat

• ROIC consistently higher than the industry average over 5 years.
• Market Share Stability or Growth – Indicates sustained competitive positioning.
• High Pricing Power – Measured by stable or rising gross margins.

7. Safety

• Low Beta (< 1) – Reflects reduced volatility compared to the market.
• Strong Credit Ratings – Investment-grade ratings (BBB or higher).

8. ESG Integration

• ESG scores above industry average (if relevant), combined with a strong economic moat.

9. Analyst Opinions

• Price-to-Target Price Ratio (< 0.85) – Indicates undervalued opportunities.