Rationale

Quality factors may signal outperformance because superior fundamentals such as sustained profitability, steady growth in cash flow, prudent leveraging, a low need for capital market financing or low financial risk underpin the demand for equity shares and support the price of such companies in the long run. From a corporate finance perspective, a quality company often manages its capital carefully and reduces the risk of over-leveraging or over-capitalization.

A behavioral explanation suggests that investors under-react to information about quality, similar to the rationale for momentum where investors chase winners and sell losers. Another argument for quality premia is a herding argument similar to growth stocks. Fund managers may find it easier to justify buying a company with strong fundamentals even when it is getting expensive rather than a more volatile (risky) value stock.

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