Quality and Profitability
Profitable, stable, conservatively financed companies have outperformed their opposites. The effect is well supported and the definition of quality is not standardised.
MadStockAlerts Research · Updated August 29, 2026
What to take away
- Gross profitability was the measure that established the effect academically.
- Quality has no single definition, which complicates comparison across studies.
- It combines naturally with value, since it separates cheap from merely broken.
- The effect appears in a widely used five-factor model as profitability and investment.
- It is the factor most vulnerable to being defined after the fact.
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The Factor With the Best Story
Quality screens for profitable, stable, well-financed firms, and it is the factor whose economic explanation is least strained.
This lesson is part of a Stock Alerts + Tools plan.
Where the effect came from
Influential research found that gross profitability, measured as revenue less cost of goods sold divided by total assets, predicted returns about as well as book to market did, and did so in the opposite direction to what a simple risk story would suggest.
The choice of gross rather than net profitability was deliberate. Measures further down the income statement are affected by discretionary spending on research and marketing, which is investment in future profits rather than a reduction in quality.
That finding is also why the factor pairs naturally with value. Sorting on cheapness alone selects companies that are cheap for good reasons; adding profitability separates the genuinely cheap from the deteriorating.
What quality is taken to mean
| Dimension | Typical measures |
|---|---|
| Profitability | Gross profitability, return on equity, return on invested capital |
| Stability | Variability of earnings and of margins over time |
| Growth | Consistency of growth rather than its rate |
| Safety | Low leverage, low beta, low bankruptcy risk |
| Payout | Dividends and buybacks, and low share issuance |
| Accruals | The gap between accounting profit and cash flow |
Six dimensions with several measures each produce an enormous number of possible definitions. That flexibility is the factor's principal methodological weakness, because a definition can be selected after seeing which one worked.
The accruals component
One component has independent support strong enough to be treated as an anomaly in its own right. Companies whose earnings are heavily composed of accruals rather than cash have tended to underperform those whose earnings are backed by cash flow.
The proposed explanation is that accruals are the more discretionary component of earnings and are less persistent, and that investors do not sufficiently distinguish the two. It connects directly to the accounting material in the fundamentals pillar.
This is the same observation that appears there as a warning sign: profit persistently above operating cash flow. The quantitative literature and the forensic accounting literature reached it independently.
Where it sits in factor models
The widely used five-factor model added profitability and investment to the earlier market, size and value factors. Investment enters with a negative sign: companies investing heavily relative to their assets have tended to underperform.
| Factor | Direction |
|---|---|
| Market | Exposure to the market as a whole |
| Size | Small over large |
| Value | Cheap over expensive |
| Profitability | Profitable over unprofitable |
| Investment | Conservative over aggressive investment |
The last row is frequently underappreciated and has a plausible mechanism: heavy investment reflects either an expectation of growth that may not materialise or the deployment of capital into projects earning below their cost.
Why the definition problem matters
A factor with many possible definitions is a factor where the risk of having chosen the definition after seeing the results is highest, and quality is the clearest case of that in the literature.
| Question | Why it decides the result |
|---|---|
| Which measures are included | Six dimensions with several measures each is a very large space |
| How they are combined | Equal weighting, ranking, or a scoring system |
| Whether the definition predates the test | The difference between a hypothesis and a fit |
| Whether it works on each component alone | A composite that only works combined is a warning sign |
The fourth row is the most useful check. Gross profitability was documented on its own and holds up on its own, which is much stronger evidence than any composite score that requires its particular combination to work.