The Marriage of Quality & Value

equity
gannatti
Head of Research, Europe
10/28/2015

The large-cap value investment style is one of the most popular styles among U.S. investment managers. Intuitively, this makes sense, as it involves following large, well-known companies in an attempt to see when their share prices dropped below what would be justified by their fundamentals. But large-cap value isn’t the only investment style there is.   Marrying Quality & Value Clearly, the focus in value strategies is on how price relates to fundamentals such as dividends, earnings or book value. Quality factors focus on the inherent stability of the fundamentals themselves, making the two approaches interesting complements. Robert Novy-Marx wrote:1
Because strategies based on profitability are growth strategies, they provide an excellent hedge for value strategies, and thus dramatically improve a value investor’s investment opportunity set. In fact, the profitability strategy, despite generating significant returns on its own, actually provides insurance for value.
We tested this premise using the MSCI USA Quality and MSCI USA Value indexes. To function as an “insurance” characteristic, the MSCI Value and MSCI Quality should not be outperforming or underperforming at the same time.   MSCI USA Quality vs. MSCI USA Value—Excess Returns against the MSCI USA Index (Rolling Three-Year) MSCI USA Quality vs MSCI USA ValueExcess Returns Appear to Offset Each Other: When the MSCI USA Quality Index was outperforming the MSCI USA Index, the MSCI USA Value Index was underperforming it—and to a similar degree. With the exception of the most recent three-year period, the potential cited by Novy-Marx appears intact.   We also wanted to further test another statement made by Novy-Marx, which was, “Adding a profitability strategy on top of an existing value strategy actually reduces overall portfolio volatility …”2 To test this, we looked at how a 50/50 allocation split between the MSCI USA Quality Index and the MSCI USA Value Index (Value & Quality Blend) did compared to the MSCI USA Value Index alone. • Did the Value & Quality Blend Outperform the MSCI USA Value Index by Itself? The percentage of rolling periods when the Value & Quality Blend outperformed the MSCI USA Index was higher than it was for just the MSCI USA Value Index—and we tested rolling periods of 3, 5, 7, 10, 15, 20, 25 and 30 years in order to see a wide range of different time frames.   • Did the Value & Quality Blend Lead to an Improved Sharpe Ratio Compared to the MSCI USA Value Index Alone? As the length of the rolling periods increased—similar to what we saw with the excess returns earlier—the percentage of times the Sharpe ratio improved also increased. Even on the shorter end, rolling three-year periods, the Sharpe ratio increased more than half the time, i.e., in more than 50% of the rolling periods examined.   Marriage of High Dividend & Quality Dividend Growth WisdomTree has two strategies that look at different types of dividend-paying stocks to fit in these categories: • Value: The WisdomTree High Dividend Index (High Dividend) searches for relatively higher-yielding U.S. dividend payers, thereby establishing a value type of exposure. With the extended period of low interest rates that we’ve seen, these types of stocks have tended to become more expensive, as they are seen as sources of potential income generation.   • Quality Dividend Growth: The WisdomTree U.S. Quality Dividend Growth Index (Quality Dividend Growth) focuses on growth and quality factors in its selection process, thereby establishing a quality type of exposure. We think the fact that these stocks represent one of the more exciting valuation opportunities in U.S. equities—given their (usually) lower debt, higher return on equity (ROE) and higher growth expectations—these stocks could command a more premium multiple. It’s worth noting that the two Indexes share 34 common constituents, comprising approximately 21% of the weight of High Dividend and 29% of Quality Dividend Growth.3   Current State of Complementarity In creating a 50/50 blend of these two Indexes today, we see:   • Smaller Sector Bets Compared to the S&P 500 Index: By itself, Quality Dividend Growth was 12% under-weight Financials, whereas High Dividend was 17% under-weight Information Technology. The 50/50 blend was still under-weight Information Technology, but now by only 8.8%. The biggest over-weight for the 50/50 blend was 5.8% to Consumer Staples.   • Attractive Valuation Characteristics: The 50/50 blend exhibited a 15.6x price-to-earnings (P/E) ratio and a 3.43% dividend yield. That’s compared to about 15.3x and 2.2%, respectively, for the S&P 500.   • Emphasis on Quality: Looking at the median three-year average return on equity of the 50/50 blend, we see 14.1%, while the number for the median three-year average return on assets is 5.7%,—figures that are actually very close to the S&P 500. Had we not complemented High Dividend with Quality Dividend Growth, we would be looking at 9.1% for the median three-year average ROE and less than 3.0% for the median three-year average ROA. For those interested in WisdomTree’s thoughts on quality, please see our full research paper The Dividends of a Quality and Growth Factor Approach.         1Robert Novy-Marx, “The Other Side of Value: The Gross Profitability Premium,” 6/12. 2Robert Novy-Marx, “The Other Side of Value: The Gross Profitability Premium,” 6/12. 3Weight in common constituents as well as weight sourced from Standard & Poor’s, with data as of 9/25/15.

Important Risks Related to this Article

Dividends are not guaranteed, and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

About the Contributor
gannatti
Head of Research, Europe

Christopher Gannatti began at WisdomTree as a Research Analyst in December 2010, working directly with Jeremy Schwartz, CFA®, Director of Research. In January of 2014, he was promoted to Associate Director of Research where he was responsible to lead different groups of analysts and strategists within the broader Research team at WisdomTree. In February of 2018, Christopher was promoted to Head of Research, Europe, where he will be based out of WisdomTree’s London office and will be responsible for the full WisdomTree research effort within the European market, as well as supporting the UCITs platform globally. Christopher came to WisdomTree from Lord Abbett, where he worked for four and a half years as a Regional Consultant. He received his MBA in Quantitative Finance, Accounting, and Economics from NYU’s Stern School of Business in 2010, and he received his bachelor’s degree from Colgate University in Economics in 2006. Christopher is a holder of the Chartered Financial Analyst designation.