Quality Investing and Industry Heterogeneity

Johannes Lundh & Sergi Estorach Cardona

Student thesis: Master thesis


This thesis aims to investigate if there exist industry differences regarding how well various definitions of the style-factor “quality” can explain stock returns. It also investigates if it is possible to improve portfolio performance by including industry heterogeneity in a quality-investing strategy.
Common definitions of firm quality are used as proxies for the quality factor, namely; gross profitability, operating profitability, return on equity, return on asset, return on invested capital, investments, and debt to equity ratio. Their power to explain stock returns is tested while controlling for size, value, and momentum. Using cross-sectional tests as well as Fama-MacBeth regressions, we find some evidence of industry heterogeneity. Technology and industrials are the industries where most metrics are significant. Energy and consumer staples are the ones with fewest significant metrics. Industry heterogeneity is also found regarding the quality metrics relative coefficient sizes.
Based on this, we test whether our definitions of quality can generate a return premium and if this premium can be improved by taking the observed industry differences into account. This is tested using portfolio sorting strategies; sorting based on firm quality and controlling for other factor loadings using Carhart’s four-factor model. We develop quality sorting strategies that take multiple firm quality metrics into account: one benchmark sorting strategy, where all industries are treated equally, and two strategies that take scaling amounts of industry heterogeneity into account.
The benchmark portfolios generate significant alphas in eight out of the eleven industries. However, these alphas are only significant for the high-quality portfolio in three of these portfolios. Furthermore, the sorting strategy is improved in two out of these eight industries when considering industry hetero-geneities. However, when incorporating industry heterogeneities, we find signs of improvement as the magnitude of the alphas is enhanced for most industries, regardless of their significance.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
Publication date2020
Number of pages135
SupervisorsMads Stenbo Nielsen