Here’s a Better Way to Identify Quality Stocks
According to new research, the annual return on a portfolio of quality stocks can be enhanced by an average of .60 percent when investors include intangible assets in their definition of quality.
As markets have become more volatile, investors have been increasingly drawn to quality stocks, those with stronger balance sheets and more stable earnings. Now portfolio managers from Vanguard have published research showing a way to improve the performance of the quality factor.
According to the research, the annual return on a portfolio of quality stocks can be enhanced by an average of .60 percent when investors include intangible assets in their definition of quality. Intangible assets include investments in research and development, software expenses, and costs associated with branding and human capital.
The definition of a quality company isn’t quite as clear-cut as those used for other popular factors, such as growth, value, and momentum, according to the paper. Some measures have been widely used to define quality companies, including low leverage, low equity dilution, and a high return on equity. Intangible assets, however, have rarely been taken into account in constructing a quality factor portfolio, but the paper said that including this measure makes sense.
“There is plenty of evidence intangible capital has become increasingly more crucial to a nation’s economic development in general and to individual success more specifically,” the authors — Mattia Bacciardi, Haifeng Wang, Jishan Mei, and Miao Yang — wrote in the paper. Intangible “assets are not easily replicated by competitors, which gives the company a competitive advantage.”
Using return data from companies in the Russell 3000 index, the researchers constructed two portfolios to study the potential impact of intangible assets. The benchmark quality portfolio, which doesn’t take intangibles into account, generated an annualized return of 13.4 percent between 1992 and 2022. Meanwhile, the other portfolio, which tilted toward companies with more intangible assets, gained 14 percent. The intangible asset portfolio also had a higher Sharpe ratio (73 percent vs. 67 percent) and a lower maximum drawdown (-10 percent vs. -13 percent) than the former.
A portfolio of stocks that includes this characteristic, “exhibits a better risk-return profile and a more desirable factor exposure.”
The researchers also found that the premium generated by intangibles is present across different industries and different time periods.
Intangible assets have also become part of the debate over the value factor, and why it underperformed for a record number of years before 2021. Now a measure of assets such as intellectual property may help identify quality companies. “Intangible capital, traditionally used to improve the value factor, has recently garnered attention by becoming a possible new addition to the quality factor.”