Creating a US quality stocks index

Abstract

A 20 year to 27 year backtesting study of an Annual Quality Index for US exchange listed stocks reveals remarkably consistent outperformance on a risk adjusted basis versus the S&P500 index benchmark: With an average of 37 stocks in the annually rebalanced portfolio, annual averages of 2.8% in alpha, 0.86 in Information Ratio and 8.5% in Jensen’s Alpha is the result. Furthermore, repeat members of the Quality Index outperform 1-time members by around 8% on average, stocks that leave the Quality Index in the successive period once they make the membership list underperform by 3% on average, and stocks that stay in the Quality Index in the successive period tend to outperform in the current period by around 4.6%. All this suggests that the Quality Index is an Elite List, with robust outperformance characteristics. This Quality Index Portfolio strategy is a type of systematic Quantamental approach to investing. The selection criteria is based on simple tenets of investing in Quality companies, looking for the top %ile stocks with high albeit stable numbers for the following 4 key metrics: (i) Revenue growth (ii) Return on Invested Capital (iii) EBITDA Margins (iv) Cash Flow Conversion (CFO/EBITDA) The study conducted built upon the author’s previous research in this area, published on Seeking Alpha. Improvements on prior versions of the research is present in this study via the exclusion of look-ahead bias present in discretionary judgement-focused sector selection filters, and via the exclusion of survivorship bias using Bloomberg’s [historical] point-in-time (PIT) data. The research is done with practical considerations in mind regarding implementation of the strategy. It is designed to be a passive, low management means of investing according to the principles of Quality Businesses Investing, whilst seeking to outperform market benchmarks.