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Diversified exposure to quality U.S. stocks

This ETF offers a low-cost way to invest in profitable companies with durable competitive advantages.

Alex Bryan 15 September, 2015 | 5:00PM
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Good companies don't always make good investments, but they may offer attractive returns relative to the market over the long term when they are trading at reasonable valuations, as they are now. Investors can get low-cost exposure to quality U.S. stocks through  iShares MSCI USA Quality Factor (QUAL) (0.15% expense ratio). This U.S.-traded ETF tracks an index that targets large- and mid-cap U.S. stocks with high returns on equity, low debt/capital ratios and low variability in earnings growth over the previous five years relative to their sector peers. It weights its holdings according to both the degree to which they exhibit these characteristics and their market capitalization. This skews the portfolio toward stocks with durable competitive advantages.

The types of stocks the fund owns have tended to hold up a little better than average during market downturns. Strong competitive advantages help protect profits and make these firms slightly less sensitive to the business cycle than less advantaged firms. However, they also can underperform for many years, particularly during strong market rallies. For instance, during the bear market from late 2007 to early 2009, the fund's index cumulatively lost 47%, while the MSCI USA Index lost 54.7%. However, it has trailed this benchmark by about 0.8 percentage points annualized since the market bottomed in March 2009. This fund launched in July 2013, so it doesn't have a long performance record. While the back-tested performance of its index looks good, there is a risk that it may not work as well out of sample.

That said, there is a compelling case for investing in stocks with durable competitive advantages and strong profitability, including their tendency to outperform in tough economic environments. In a recently published study titled Quality Minus Junk, Cliff Asness and several other principals at AQR found that stocks with high and growing profitability, high payout rates and low market volatility and fundamental risk historically outperformed their less advantaged counterparts.

These findings are consistent with research that shows that there has historically been a positive relationship between profitability and future stock returns. This effect is stronger after controlling for differences in valuations because more-profitable stocks tend to trade at higher valuations, which have historically been associated with lower returns.

There isn't an intuitive risk-based explanation for this effect. However, highly profitable stocks tend to perform similarly and there is a risk they could underperform the market for extended periods. The risk story has a little more merit after controlling for differences in valuations. The market may assign similar valuations to two stocks with different expected future profits if the more profitable stock is riskier in some way.

A more compelling explanation is that investors may not fully appreciate the long-term sustainability of highly profitable firms' earnings power and systematically undervalue them. To the extent that investors catch on and bid these stocks' valuations up, they may offer a smaller return advantage going forward.

This fund only directly captures profitability through its return on equity selection criterion. On this metric, and return on invested capital, the fund's holdings look significantly more profitable than the constituents of the broad Russell 1000 Index. Over the trailing 12 months through August 2015, the fund's holdings generated an average return on invested capital and ROE of 21.4% and 32.1%, respectively. The corresponding figures for the Russell 1000 Index were 12.4% and 19.4%, respectively.

The fund's debt/capital selection criterion indirectly skews its portfolio toward profitable companies because more-profitable firms tend to be less dependent on debt. This metric also penalizes companies that generate high ROE through debt financing. Targeting stocks with low per-share earnings-growth variability during the past five years tilts the portfolio toward consistent growth companies. It also penalizes stocks that erratically issue new shares to finance their growth. These three selection criteria favour wide-moat stocks, which currently account for more than 60% of the portfolio.

While overpaying for quality can wipe out its benefits, the fund's holdings are currently trading at reasonable valuations. At the end of August, the fund was trading at 18.5 times forward earnings, only slightly higher than the corresponding value for the Russell 1000 Index (17.7). Based on Morningstar equity analysts' fair value assessments of the fund's underlying holdings, it is trading close to fair value, as of this writing.

The fund employs full replication to track the MSCI USA Sector Neutral Quality Index, which targets a subset of large- and mid-cap stocks from the MSCI USA Index. It specifically screens for stocks with high return on equity, low debt/capital and low volatility of year-over-year per-share earnings growth during the past five years. MSCI assigns a sector relative composite quality score to each stock in the MSCI USA Index based on these three metrics. It then selects the top scoring stocks within each sector and sets its sector weightings equal to those of the MSCI USA Index on each rebalancing date. Stocks with higher sector-relative quality scores and market capitalizations receive larger weightings in the index. However, the index adjusts these weightings to maintain sector neutrality. This adjustment may slightly reduce the portfolio's quality tilt and increase turnover. MSCI reconstitutes the index twice a year in May and November.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.

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