Reaping the Size and Value Effects: Controlling for Pure Quality

Sammanfattning: We investigate if small and low Market-to-Book firms have higher risk-adjusted returns when controlling for quality. We define quality characteristics as something investors should be willing to pay a higher price for, all else equal. The analysis is based on all common stocks in the Swedish stock market for year 1996- 2014. We show that quality companies have higher Market-to-Book, and that larger firms earn a price premium when holding Quality constant. We introduce a new Pure Quality metric which is adjusted for a firm's Market-to-Book and Size, resulting in a metric that is predicting subsequent returns. A trading strategy that takes a long position in high pure quality, small and low Market-to-Book firms and that goes short low pure quality, large and high Market-to-Book firms generates economically large and statistically significant three-factor alphas at the 1% level. This finding is also robust to the QMJ factor. Furthermore, we argue that the price of quality characteristics indicate tendencies in valuation irrationality and predict the strategy return. Indeed, during the rise of the internet bubble year 1999 the price of profitability peaked and the strategy underperformed. However, after the burst of the bubble the price adjusted and the strategy more than recovered.