The quality factor: how profitability and earnings stability drive long-run returns
The quality factor targets companies with strong profitability, stable earnings, and low financial leverage. Novy-Marx (2013), in The Other Side of Value: The Gross Profitability Premium, showed that highly profitable firms—measured by gross profit relative to assets—have significantly outperformed less profitable ones, even after controlling for the market, size, and value factors.
What the quality factor is
Quality, as a systematic factor, translates the preference for financially sound businesses into a measurable, repeatable investment process. The challenge is that quality is not a single metric: profitability, earnings stability, earnings quality, and financial leverage each capture a different dimension of what makes a company sound.
Novy-Marx (2013) used gross profit divided by total assets as his primary signal, arguing it is a cleaner measure of economic profitability than net income because it is less susceptible to accounting manipulation. A parallel research strand developed by Asness, Frazzini, and Pedersen—published as Quality Minus Junk (2019)—defines quality using a composite of profitability, earnings growth, safety (low leverage and earnings volatility), and payout ratios. Both approaches agree on the core finding: high-quality companies have historically delivered risk-adjusted returns above their low-quality peers.
How the quality factor works
A quality strategy scores and ranks companies on its chosen metrics, overweights the highest-scoring assets, and rebalances on a fixed schedule. The operational challenge relative to momentum or value is that quality metrics are accounting-based and depend on reported financial statements, introducing a lag between economic reality and measured quality score.
Quality has shown a low or negative correlation with the value factor—quality stocks tend to trade at premium valuations rather than discounts. This makes quality a useful complement to value in a multi-factor portfolio: the two factors tend to disagree on different assets, providing diversification across the combined factor exposure.
What the evidence shows
Novy-Marx (2013) found that profitable firms outperformed unprofitable firms by approximately 3.4 percentage points per year in US data from 1963 to 2010, with similar results in international markets. This premium was approximately equal in magnitude to the value premium and statistically independent of it.
Asness, Frazzini, and Pedersen extended this to a broader quality composite and documented the premium across 24 equity markets from 1986 to 2012. The quality factor showed greater consistency through the 2010s than value, as high-profitability businesses—including many in the technology sector—benefited from the structural shift toward intangible-asset-intensive business models.
Limitations and trade-offs
Quality is inherently backward-looking. Accounting-based metrics measure past profitability and earnings stability; they do not guarantee future performance. A company can show strong quality scores as it approaches a disruption that will erode its competitive position—quality is not a moat in itself.
The definition of quality is not standardised. Implementations vary widely: some use return on equity, some use gross profitability, some use composite scores combining several metrics. Comparing quality exposure across portfolios requires careful examination of what the underlying metric actually measures.
Quality and growth overlap substantially in contemporary markets. High-profitability companies often trade at high valuations. This means a quality tilt may introduce unintended growth or technology concentration, particularly in periods when high-quality businesses are also highly valued—introducing valuation risk that a pure quality screen does not capture.
The quality factor in pfolio
pfolio does not implement an explicit quality factor tilt. The momentum-based selection methodology may implicitly favour quality companies at certain points in the cycle, as trending assets often include businesses with strong fundamentals. For investors interested in evaluating their holdings against quality criteria, pfolio Insights provides risk and return metrics across all assets and portfolios. The how we build portfolios help article describes the construction methodology in detail.
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