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Research

The Innovation Factor: The Leading Edge of QualityTheInnovationFactor:TheLeadingEdgeofQuality

By Gavin Smith — Oct 20, 2022

5 mins

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There is no clear-cut definition or consensus around what constitutes quality when evaluating a potential investment. Quality factors are designed to identify stocks of companies that are profitable, stable (and are therefore expected to maintain profitability in the future), financially healthy and growing. And while the definition of quality can vary across investors, these attributes broadly capture the spirit of what’s typically included in discussion of quality. But of course, there are other firm attributes that can fit into the quality ‘bucket’. Our research has shown that a firm’s innovation – or its intangible assets – can meaningfully expand on other aspects of firm quality.

Questions of Quality

In recent years, the quality factor hasn’t performed as expected during periods of extreme market upheaval and volatility, leaving active investors to search for answers. We believe there are several explanations for this departure from expectations that relate to how quality factors are constructed. First, quality factors can easily take on biases against firms with negative earnings or no sales. But the absence of earnings or sales may not necessarily equate to low quality, rather, the occurrence may be related to transitory issues that may have little impact on the future growth trajectory of a firm.

Second, quality factors (and many quantitative factors as well) have typically relied on ‘hard’ information such as financial data from income statements, balance sheets and cash flow statements. However, companies are remarkably multidimensional so ‘hard’ data may not properly capture the true quality attributes of a firm. This line of thinking has contributed to the interest in ESG issues that relate to company stakeholders. It has also led to increased interest in understanding the ‘soft’ attributes of firms, such as culture and strategic vision. Lastly, quality factors have generally not adapted to reflect the rise of asset-light or ‘weightless’ firms1. Indeed, over 70% of the market value of companies in the S&P Europe 350 Index is now composed of intangible assets. The trend is even more striking in the US, where that value stands at 90% for the S&P 500 Index (Exhibit 1). Furthermore, intangible assets as a share of GDP overtook tangible assets in the 1990s and continue to rise today. While primarily a developed market phenomenon, there is new evidence that intangibles are also a growing share of total global assets, indicating that this shift in developed markets does not merely reflect the offshoring of manufacturing to emerging markets, but illustrates a more profound global shift.

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  • By Gavin SmithHead of Equity Research and Sustainable Investing, PGIM Quantitative Solutions
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