From a behavioural perspective the notion that there is some form of premium attached to investing in higher quality companies is something of a puzzle. If anything, one would expect loss-averse investors to overpay for securities with perceived stability and downside protection, and bear a cost in terms of lower risk-adjusted returns. Research, however, suggests that the reverse is true[i]. I have written previously about the potential behavioural explanations for value and momentum factors, but for the quality factor developing such an account is more challenging.
Compared to value and momentum, quality suffers from a somewhat amorphous definition, with a vast range of often distinct metrics employed to describe it. Some combination of earnings stability, low financial leverage and high profitability appear to be the most consistently applied characteristics. There is also debate around under what conditions the quality factor becomes apparent (delivers superior risk adjusted returns); often this is when applied in a long-short structure (long high quality / short low quality). It is also often effective when held as a complement to another factor (such as value or size), rather than on a standalone basis.
It is certainly possible that quality might not be a genuine factor. There are many who argue that excess returns to quality are a consequence of a market regime defined by a prolonged decline in interest rates – leading to a sustained re-rating for stocks with ‘bond-like’ qualities*. Furthermore, the aforementioned definitional uncertainty also leads to a potential data mining problem – if you test enough ‘quality’ metrics, some are likely to prove significant. The purpose of this post, however, is not to debate whether the quality factor is robust, but rather if it is – can there be a behavioural explanation?
It is important to make a distinction between the legitimacy of a quality equity factor and whether investing in quality companies can be an effective investment strategy. If you can select companies with quality characteristics that are able to ‘beat the fade’ embedded in their valuation you are likely to be successful. This, however, is reliant on having the skill to selectively identify these names in advance. By contrast, the existence of a quality factor suggests that there is a return advantage to systematically filtering companies by a certain set of defined criteria.
Of course, the quality factor does not require a behavioural explanation to exist. One of the main problems with factor premiums is that there is no certainty about what causes an anomaly and we are forced instead to speculate. This inability to truly understand the drivers of a factor means that we can never observe when something changes and the premium expected from a previously robust factor is extinguished.
In the case of the quality factor, a premium might be caused by a structural issue such as that highlighted by Frazzini and Pedersen[ii], who argue that constrained investors (who cannot utilise leverage) instead allocate to higher beta assets to boost a portfolio’s overall market sensitivity, leading to lower risk adjusted returns from higher beta assets. This argument can also be extended to tracking error and beta restricted active equity strategies that have limitations on holding significant amounts of higher quality stocks. Whilst there are behavioural elements embedded in this argument, these are more structural explanations**.
However, let’s assume that some form of quality premium exists in equity markets because of behavioural issues. What could they be?
Incentives: As always, incentives matter. If we assume that the richest rewards come to professional investors who either: a) Generate abnormally strong performance and raise a large amount of assets, or b) Generate strong returns by levying performance fees, then they may be inclined to embrace / overpay for volatile stocks with the potential for the highest payoffs[iii].
Present bias: We have a tendency to overweight near-term rewards. Quality stocks deliver a long-term payoff (through the compounding of high returns on capital), whereas lower quality stocks provide the possibility of a high near term payoff. If this is the case, we are likely to overvalue the potential short-term benefits of low quality companies (with an option like payoff), and undervalue the long-term benefits of quality companies.
Overconfidence: As investors we have an exaggerated belief in our own abilities and therefore may be reticent to invest in higher quality, stable companies and instead feel that our expertise is best rewarded by selecting companies with higher leverage, more variable earnings and greater earnings upside potential.
Focus: The myopic nature of financial markets may simply mean that investors focus on the wrong things – obsessing over short-term earnings announcements, corporate news flow and macro-economic issues – rather than long-term profitability.
As with all equity factors, attempts at identifying behavioural explanations for the existence of a premium for high quality stocks is a somewhat futile exercise – we will never know the answer. There is, however, some credibility to the notion that incentive structures, perceived pay-off profiles and temporal valuation issues could lead to a sustained mispricing in this area***, which could be systematically exploited. Yet given the oceans of behavioural research conducted in recent years, it is possible to create mildly plausible explanations to justify virtually any equity risk factor.
* Valuation matters. Even if there is a structural premium for a certain equity factor, if it performs very well and becomes expensive, then you are unlikely to be enjoying that premium in the future (momentum will be an exception to this given the fluctuating composition).
** I acknowledge that a high quality equity strategy is not analogous to a low volatility or low beta equity approach; however, I would expect in most scenarios higher quality stocks to exhibit a lower beta and lower volatility than lower quality stocks.
*** It is certainly possible to argue that some of the behavioural explanations I give for the existence of the quality factor would seem to contradict the value factor (which is, I think, more robust than quality).
[ii] Frazzini, A., & Pedersen, L. H. (2014). Betting against beta. Journal of Financial Economics, 111(1), 1-25.
[iii] Bali, T. G., Cakici, N., & Whitelaw, R. F. (2011). Maxing out: Stocks as lotteries and the cross-section of expected returns. Journal of Financial Economics, 99(2), 427-446.