Why Focusing on Quality is Timeless for Equity Investing

What is quality anyway?

Understanding the concept of 'quality' in stock investing hinges on the criteria used to evaluate it. Arguably the most well-known/longstanding is the Fama-French Five-Factor Model. Within this model, we particularly focus on the profitability factor.

Profitability here refers to the historical ability of companies with robust operating profitability to generate higher returns than those with weak operating profitability. This is an indication of operational efficiency and a competitive edge in the market.

Furthermore, the benefits of focusing on the quality factor appear to have strong longevity and persistence. To quote a CFA Institute whitepaper titled "Fama and French: The Five-Factor Model Revisited," by Derek Horstmeyer, Ying Liu, and Amber Wilkins:

"RMW is the single factor that has consistently delivered excess returns. Overall economic cycles since 1963, going long high-quality stocks, or profitable firms, and shorting their low-quality, unprofitable counterparts has been a great investment strategy. And the power of the factor has not diminished."

An ETF example of quality's potential

I believe that when it comes to delivering consistent exposure to quality stocks, few ETFs match the potential and past performance of the WisdomTree U.S. Quality Dividend Growth Fund (DGRW).

This ETF stands out in the market not just for its focus but also for its unique approach to stock selection and weighting. While it does select its holdings from the WisdomTree U.S. Dividend Index, DGRW applies additional criteria to refine its selection.

This ETF focuses on companies with positive long-term earnings growth expectations and those that have shown strong historical performance in terms of return on equity (ROE) and return on assets (ROA) over a three-year period.

These metrics are crucial as they reflect a company's efficiency in generating profits and managing its assets, key indicators of its overall financial health and quality.

DGRW’s uniqueness also lies in its approach to weighting its approximately 300 stocks. Unlike traditional index funds that might weight stocks based on market capitalization, DGRW uses a fundamental indexing strategy.

This strategy weights stocks based on the projected share of aggregate cash dividends each company is expected to pay in the coming year, using the most recent data on dividends per share.

This method not only emphasizes companies with solid dividend histories but also those projected to be reliable dividend payers in the future.

Historically, DGRW has outperformed both broad-market index ETFs like the SPDR S&P 500 ETF (SPY) and lower-cost dividend growth ETFs like the iShares Core Dividend Growth ETF (DGRO) on both a total and risk-adjusted return basis:

Another cool fact? DGRW has also historically provided very high loadings to both the profitability (RMW) factor, even beating out a "brand-name" quality factor ETF like the iShares MSCI USA Quality Factor ETF (QUAL).

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.