In the last blog, we discussed how long-term investing requires looking at metrics that go beyond the standard GAAP financial accounting measures and why the Economic Dimension (ED) score from RobecoSAM was the sustainability score that best complimented the long-term aim of the S&P LTVC Global Index. While the ED score may be a key metric of a firm’s long-term focus on its goals, it is also important to the index to identify how these policies have translated themselves and are reflected in the quality of a company’s earnings, balance sheet, and profitability.
It is safe to say that the definition of quality and the characteristics of a high-quality company will generate numerous and varied responses from academics and analysts alike. In addition, the difference in opinion will persist in not only the definition, but also the number of metrics that should be used to gauge quality. Our colleagues previously examined the quality debate and presented their findings and S&P Dow Jones Indices’ stance in “Quality: A Distinct Equity Factor?” (Ung and Luk). The paper presented the framework for defining quality which included categories such as profitability, earnings quality, and strength in balance sheet. The report included back-tested performance results, which showed that the proposed quality factor was beneficial in contributing to excess long-term investment returns.
For the S&P Quality Indices, the following three metrics are used to define a quality company.
- Return on equity (ROE) was selected as the preferred metric for profitability, and companies with higher ROEs have sustained competitive advantages such as branding or competitive positioning, which help them maintain their profitability.
- Quality of earnings was another criterion to determine quality as measured by the balance sheet accruals (BSA) ratio (change in net operating assets/average operating assets). The BSA provides a way to measure how a firm scores in its earnings management; higher accruals are a potential red flag as higher levels of noncash items may lead to financial statement revisions.
- Finally, the financial leverage ratio was selected as the third metric to gauge balance sheet strength, with the rationale that high-quality companies have the ability to finance their ongoing business activities without having to incur excessive debt levels, protecting them in times of crisis.
One of the key findings from Ung and Luk’s paper was that although quality strategies have performed well on their own, they appeared to work well when combined with other factor strategies as well. This was the basis for our thinking to combine quality with economic sustainability factors to create the S&P LTVC Global Index.
In our final blog of the series, we will dig deeper into the unique structural aspects and performance attributes of the S&P LTVC Global Index.