DOES QUALITY STOCK OUTPERFORM THE MARKET IN DOWNTURN PERIODS?

• Author: Sedeek, Doaa Samy

INTRODUCTION

Quality investing gains its importance by the 2000s since the occurrence of the financial crisis as dot com bubble in the U.S. stock market and it has been gaining more attention by 2007-2008 global financial crisis. Practitioners and academicians then have argued that firms with certain characteristics such as safety and sound financial position will have better performance in turmoil periods than the stock market (Zaremba & Shemer, 2017).

Quality investing is not a new concept in finance, especially in equity investing, and it is well grounded in fixed income securities. Bender and Samanta (2017) reported that quality is not only attached to a specific asset class, but it can be considered as an individual building block or factor in asset allocation. Quality investing in equity is traced to the 1930s in which Benjamin graham- the father of value investing-stated that there were several criteria for picking quality stock. These criteria are still examined by several practitioners and asset management agencies as standard and poor (S&P), Morgan Stanley capital international (MSCI) and FTSE Russell, that have developed indices for investment based on the quality factor (Lim et al., 2015).

The criteria of stock picking introduced by Benjamin graham contain firm quality indicators (i.e. debt ratio, current ratio, earnings growth, and stability of earnings) and valuation indicators as price/earnings ratio, book to market ratio, and dividends to price ratio. Benjamin graham also advocated the existence of the behavioral aspects and emotional mistakes that lead to generating opportunities for mispricing (Oppenheimer, 1984, Howard, 2014).

There is a lack in the literature in equity investment on what precisely quality investing is or what the main descriptors are. Most of the previous studies stated that quality factor is a complex multi-facet style of investment that combines three main approaches (i.e profitability, earnings stability, financial robustness) as in Piotroski (2000), Asness, Frazzini, and Pedersen (2014). Another strand of researches considers quality investing as a uni-facet style of investment that relies on one financial indicator as profitability in the study of Novy max (2013). Further, it is reported by Bender et al (2013) that quality factor is commonly associated with a firm's competitiveness, efficiency, transparency, growth, financial and operating leverage, profit sustainability, and return-on-equity (ROE).

Most of the literature on quality matrices relies on quantitative measurements. Hanson and Dhenuka (2015) engaged qualitative attributes to quality measurement (i.e. corporate culture, corporate leadership) and they defined the junk stock -which is the opposite of quality stock, as the stock the company characterized by low profitability, high debt, and fluctuated earnings. Furthermore, Ung, Luk, and Kang, (2014) stated that quality indicators can be classified into qualitative as the manager ability to exercise prudence in the administration of the companies' affairs and quantitative as characteristics of generating higher revenue and cash, and maintaining more stable growth and adopting a conservative and effective capital structure that allows firms to grow.

Additionally, Schroder (2014) stated that higher quality companies tend to be more cash generative, higher cash flow distribution to the shareholders or high payout ratio and able to meet the debt obligations. Moreover, this allows quality companies to continue to reinvest into projects that deliver returns allowing them to grow more sustainably than other companies.

It is argued that the concept of quality stock is derived from the quality firm in which few studies (Anderson & Smith, 2006; Antunovich, Laster & Mitnick, 2000)) stated that high quality firms are high quality investment. This finding is attributed by Sherfin (2001) to the representativeness heuristic as investors associate quality stock with quality firms. The term quality can also be defined differently from either the investor point of view or the manager point of view. It can be seen by the manager lens as stock of the companies with high credit rating, high management quality, corporate governance, ethical issues or general financial strength and sustainability. However, differently to some degree, investors see the quality companies as the companies with a higher stability condition, safety, profitability, and sustainable dividends growth (Antunovich., 2000; Zaremba, 2016).

Quality investing is expected to mitigate the influence of fear in distress time on the stock market performance because it shows less volatility than most of the stocks in the market. Moreover, it is stated that when flight to quality takes place, quality factor delivers better performance through lowering the flights of the capital out of the stock market to another safe asset market in turbulent periods (Lim et al., 2015; Chen, Hope, Li, & Wang, 2018).

This study investigates whether the main descriptors of quality stock, under the Egyptian context, are return on equity (ROE), as a measure of profitability, and return volatility, as an indicator of safety. This study also investigates whether there is a significant difference between highest sorted quality portfolios and lowest quality sorted portfolio, especially in periods of stock market falling condition. In addition this study investigates whether the quality sorted portfolios outperform the market portfolio in downturn periods.

THEORETICAL BACKGROUND

In classical finance theory, it is assumed that investors are rational "no role for sentiment" and hold well diversified portfolios and trade infrequently to minimize taxes and other investment costs. This leads to the equilibrium in which prices equal to the intrinsic value that is computed by discounting the value of expected future cash flows, and the cross-section of expected returns depends on the cross-section of systematic risks. Investors behave differently in which they trade frequently and have limited stock selection ability, incurring unnecessary investment costs and return losses (Baker & Wurgler, 2006).

In 1952, Markowitz developed the modern portfolio theory (MPT) that states that investors select portfolio based on maximizing the expected return for a given level of risk or to minimize the risk for a certain level of the expected return. So, the optimal security design under MPT combines high return and low risk. The MPT relies on the cornerstone of the standard finance which all theories and models rely on a positive linear relationship between risk and return based on the assumption of risk adverse investors. However, the empirical findings show the opposite (Shefrin, 2001; Ricciardi, 2008).

Merits of MPT are embedded in simplifying the factors needed to select the portfolios (i.e. expected return, variance), whereas the demerits lie in the difficulty in determining the correlation matrices to ensure the diversification among many securities. Moreover, other demerits are rooted in the insurance of market perfections to get the best diversified portfolios. It considers the expected return and variance in a static mode without reflection to the turmoil periods that add dynamicity to investment models. It ignores the behavioral aspects in the investment decisions, and it handles the upside and downside variance equally in investment risk measurement while it is found empirically that the downside variance is more important in downturn periods (Qian & Gorman 2001; Curtis, 2004; Mau, 2009).

Additionally, the MPT or mean-variance framework provides general structure for the whole process of investment as determining expected return and level of risk with the covariance between securities, but it does not provide a methodology for selecting the security. Thus, models such as CAPM, APT, and Fama-French risk factors try to present risk factors for describing the market performance as well as constructing portfolios (Subathra & Mohideen, 2017).

Modern portfolio theory implies that any change in the asset risk level is due to the changes in the firm fundamental and no opportunity for the investors' behavioral aspects to have an impact on investment decisions. However, many studies (e.g., Rupande, Muguto & Muzindutsi, 2019; Baker & Wurgler, 2006, stated that investor sentiment like fear can cause changes in the risk distribution of the asset returns and consequently, the asset allocation is manipulated. In the same respect, the expected utility theory stated that the degree of risk aversion is determined by the concavity of the utility function over the levels of wealth. The theory does not give further explanation for the states of extreme risk aversion that happens when the investors are unwilling to bear more risk giving the high downside risk (Rabin & Thaler, 2001).

Therefore, behavioral finance as a new paradigm tries to engage psychology on the financial decision-making process and it assumes that market participants are normal. Also, it presents explanations for series of anomalies that traditional finance is unable to explain. Emergence of behavioral finance is backed by Kahneman and Tversky (1979) that introduced prospect theory, that replaced expected utility theory of standard finance to add the investor reference point in evaluating the possibility of a specific outcome in terms of gain or losses (Ricciardi & Simon, 2000; Statman, 2008).

Since 2000, there is an increasing trend in the literature to distinguish between the concept of risk from the two main paradigms of finance (standard finance and behavioral finance). Under the behavioral finance paradigm, the risk is considered as a combination of objective measures (i.e. standard deviation, beta) and subjective indicators that are based on investor sentiment and emotions. Further, the behavioral finance implies that there is an inverse relationship between risk and return because of...