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The quality factor captures the tendency for companies with strong fundamentals, high profitability, stable earnings, and conservative financial policies, to outperform companies with weak fundamentals. While value and momentum have longer academic pedigrees, quality was formalized by Robert Novy-Marx (2013), who demonstrated that gross profitability (revenue minus cost of goods sold, scaled by assets) was a strong predictor of future stock returns. Asness, Frazzini, and Pedersen (2019) later defined quality more broadly through their "quality minus junk" framework.
Quality is typically measured using a combination of profitability metrics (ROE, ROA, gross margins), earnings stability (low volatility of earnings growth), financial strength (low leverage, high interest coverage), and payout characteristics (stable or growing dividends, limited share issuance). Unlike value, which has a single dominant metric (price-to-book), quality is inherently multi-dimensional, and composite scores are the standard approach.
The economic rationale for the quality premium is somewhat paradoxical. If quality companies have superior fundamentals, why are they not already priced to reflect this? One explanation is that investors systematically underprice quality because they are attracted to speculative, high-variance stocks (the "lottery ticket" preference). Another explanation focuses on the slow speed at which fundamental quality is reflected in prices: improvements in profitability and balance sheet strength accumulate gradually, and the market may not fully price in the compounding advantages of high quality until they manifest in earnings results over multiple quarters.
Quality and value are often combined because they target different stocks and complement each other well. Value strategies tend to select distressed, low-quality companies, which introduces the risk of value traps. Adding a quality filter to a value strategy removes the most dangerous deep-value names while preserving the value premium. This is sometimes called "quality at a reasonable price" (QARP) and has been employed by investors ranging from Warren Buffett (who implicitly uses quality-value) to systematic factor funds.
Implementing quality strategies requires careful metric construction. ROE can be inflated by financial leverage, so ROA or return on invested capital (ROIC) may be preferred. Earnings quality measures, such as the ratio of cash flow from operations to net income, help identify companies that rely on accrual accounting to inflate reported earnings. Piotroski's F-Score, a nine-component binary scoring system, is a widely used composite quality measure that combines profitability, leverage, and operating efficiency signals.