How is the quality factor defined in equity investing and which metrics best capture it?

The quality factor in equity investing captures companies with strong fundamentals that tend to deliver superior risk-adjusted returns. Unlike value or momentum, there is no single universally agreed-upon definition, which is partly why it seems vague.

Common Quality Metrics:

Academic Foundations:

1. Novy-Marx (2013): Defined quality primarily through gross profitability (gross profit / total assets). Firms with high gross profitability outperformed by ~4% annually.

1. Asness, Frazzini, Pedersen (2019): Defined quality as a composite of profitability, growth, safety, and payout. Their Quality Minus Junk (QMJ) factor showed significant returns across global markets.

1. Fama-French Five-Factor Model: Added profitability (RMW — Robust Minus Weak) as a factor, closely related to quality.

Practical Scoring Example:

Willowtree Asset Management constructs a quality score using:

• Return on equity: top quartile = 3 pts, second = 2, third = 1, bottom = 0
• Debt-to-equity: bottom quartile (least debt) = 3 pts, ascending
• Earnings stability (5-year coefficient of variation): lowest = 3 pts
• Accruals ratio: lowest = 3 pts

Maximum score = 12. Stocks scoring 9+ are "high quality."

Why Quality Works:

Investors historically underpriced stable, profitable companies because they appeared "boring." The quality premium may also reflect compensation for short-horizon investors who chase momentum and novelty.

CFA Exam Focus: Know the key metrics, be able to compare quality with other factors, and understand that quality definitions vary across index providers.

Check our CFA equity factor investing question bank for practice.