FTSE Russell Insights

Searching for the equity Armani: the rationale for Quality stocks at a reasonable price

Ryan Giannotto

CFA, Manager Equity Index Research
  • The quality factor is associated with higher risk-adjusted returns but comes at the cost of paying a substantial premium in valuation.
  • This blog explores simultaneously tilting into both quality and value in a 2-to-1 ratio, capturing the resilient characteristics of quality companies without overpaying for earnings.
  • This “Armani on sale” approach to investing is exemplified by the Russell 1000 2Qual/Val 5% Capped Factor Index, which melds these contrasting factors for superior returns and portfolio fundamentals.

We are all familiar with the reputation for fine thread counts and exquisite craftmanship of haute couture brands like Armani, but we also know that such quality commands a premium. Conversely, the value trap nature of bargain brands is a common siren song—sure the clothing is cheap, but at what cost? Once they have been through a few cycles, they may fall apart; you might even say they have poor fundamentals! 

Equities are intangible—and lack the je ne sais quoi of a fine Italian suit—but the same trade-off between these factors nonetheless applies. More concerning still, excesses in both the directions of quality and value can prove suboptimal from an investment perspective. Consider that a fixed tilt to quality produces a Price to Sales ratio 2.3 times higher than a tilt of equivalent strength into value —is there a way to achieve quality at a reasonable price (i.e., sans the limited-edition valuations)? The Russell 1000 Qual2/Val 5% Capped Factor Index seeks to fulfill this mandate, to uncover the metaphorical Armani on sale opportunities of the large cap universe.

Factor Bending: Quality as a Science

Much as in the world of fashion, quality and value are negatively correlated factors in a financial setting as well. The logic is intuitive, but the results are quite powerful as showcased in the Russell 1000 Qual2/Val Index, which leverages the anti-correlative properties of these factors. Since 2010, the excess returns of quality and value, as described by the FTSE Russell Global Fixed Tilt Index Series, realized a daily correlation of -0.588.

Quality and Value Daily Correlations Since 2010

The chart displays the excess returns of quality and value since 2010, as described by the FTSE Russell Global Fixed Tilt Index Series, realized a daily correlation of -0.588.

Source: FTSE Russell Data, as of March 2023. Past performance is no guarantee of future results. Please see the disclaimer for important legal disclosures

So consistent is this relationship that tilting into either quality or value will generally produce negative exposure to the other factor—an unintended bet that requires active correction. The Russell 1000 Qual2/Val Index, however, extends this factor neutralization process yet further with direct bets on the oppositional factor. Conceptually, the methodology forces together the disparate circles of a Venn Diagram to exploit the resultant overlap.

What characteristics define the oppositional factors of quality and value? FTSE Russell takes a comprehensive view to factor construction, believing that a multidimensional analysis best captures the nuances of factor behavior throughout market cycles. In the case of value, stocks are evaluated on their earnings yield, cash flow yield, and sales to price ratio, with each measure given a one-third weight. For quality, companies are assessed equally in terms of their leverage (cash flow coverage ratio) and their profitability, which in turn examines Return on Assets (ROA), change in turnover and accruals.

Active Returns: Quality, Value & Quality at a Reasonable Price

This chart shows how a tilt to quality stocks has rewarded investors for most of the 2010s.

Source: FTSE Russell Data, as of March 2023. Past performance is no guarantee of future results. Please see the disclaimer for important legal disclosures

Each of the base metrics is measured by z-score, or the number of standard deviations each company falls from the average, capped on a range of plus or minus three. These scores are then renormalized by the gaussian error function to produce results in the range of zero to one, to which the factor tilt powers are applied as an exponent. In sum, this process generates the scalars for quality and value that are directly multiplied against market cap weights to create the new factor tilt portfolio. The Russell 1000 Qual2/Val Index raises quality scores to the second power and value to the first—the emphasis is finding Armani on sale, not quality at the bargain store. Another important consideration is that the value and quality tilts are not two separate screens, but rather they work in conjunction with each other as a unified methodology.

Quality Performance, Discount Pricing

This hybridization of competing factors begets a compelling narrative in terms of performance. Indeed, the 2-1 factor tilt strategy achieves an outcome where quality and value each compensate for the other’s weaknesses as factors cycle in favorability.

Risk/Reward Factor Strategies: 2001-2023

The chart illustrates how a Qual2/Value strategy delivered better returns, at lower volatility, than most single factor or vanilla approaches.

Source: FTSE Russel/ Data, as of March 2023. Past performance is no guarantee of future results. Please see the disclaimer for important legal disclosures

The period since December 2013 exemplifies these characteristics in two clear phases of performance behavior. Foremost, in the timeframe from January 2017 to August 2020 specifically, value declined 21.4 percentage points on a relative basis to the benchmark, while the Russell 1000 Qual2/Val Index staved off 88.5% of this downdraw. Decidedly is novel concept, a value-oriented strategy that not only remained market competitive, but outperformed by 30% through the 2010s!

After August 2020 however, as quality’s relative performance advantage recessed, the Russell 1000 Qual2/Val Index still advanced 9.19 percentage points on a relative basis through March 2023 as value rebounded. Extending the analysis back to December 2001, the 22-year history further corroborates the merits of melding these counteracting factors, both on an absolute and a risk-adjusted returns basis. Specifically, the Russell 1000 Qual2/Val Index exhibited 28.0% greater risk efficiency than the benchmark, and 15.5% and 7.4% than either value or quality indices individually.

  Russell 1000 Quality Value QARP QARP Gains
Quality Metrics Turnover 0.046 0.052 0.065 0.063 39%
ROA 10.63% 15.56% 7.49% 11.86% 12%
Leverage 0.546 0.731 0.466 0.620 14%
Value Metrics Earnings Yield 4.19% 4.64% 6.66% 4.73% 13%
Sales to Price 0.447 0.386 0.891 0.676 51%
Cash Flow Yield 7.06% 6.46% 11.71% 8.22% 16%

The narrative of anti-correlation further enrichens when examining portfolio fundamentals, as the quality index generally rates poorly on value metrics (i.e., more expensive), and value likewise disappoints by quality standards (i.e., more indebted, less profitable). For instance, quality achieves an ROA 109% higher than the value index can manage, while value attains a cash flow yield 81% greater than that for quality. The disparities are stark.

What is striking about the Russell 1000 Qual2/Val approach however, is it proves the desired fundamentals for quality and value are not mutually exclusive; indeed the strategy moves in both directions simultaneously. Notably, the strategy secures core quality characteristics—improving cash flow coverage by 7.4 basis points and enhancing ROA by 12%—all while exhibiting better than benchmark pricing. Although it may not necessarily improve your wardrobe, finding quality in the market without overpaying does capture the magic of Armani on sale.

Stay updated

Subscribe to an email recap from:


© 2023 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) FTSE Fixed Income Europe Limited (“FTSE FI Europe”), (5) FTSE Fixed Income LLC (“FTSE FI”), (6) The Yield Book Inc (“YB”) and (7) Beyond Ratings S.A.S. (“BR”). All rights reserved.

FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “FTSE4Good®”, “ICB®”, “The Yield Book®”, “Beyond Ratings®” and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.

All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of FTSE Russell products, including but not limited to indexes, data and analytics, or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.

No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.

No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this document should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset or whether such investment creates any legal or compliance risks for the investor. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset nor confirmation that any particular investor may lawfully buy, sell or hold the asset or an index containing the asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back-tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.

This document may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.

No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, YB, BR and/or their respective licensors.