Quantitative research has formalised the characteristics of businesses that consistently compound capital. In their landmark paper “Quality Minus Junk”, researchers defined the variables that drive the quality premium:
Measured as profits per unit of book value (using gross profits, operating margins, free cash flows, and accruals). Highly profitable companies command a premium because they generate real economic surpluses.
Measured as the prior five-year growth in profitability metrics.
Measured by both market-based metrics (low beta) and fundamental metrics (low leverage, low earnings volatility, and low credit risk).
High-quality firms (high profitability, high growth, high safety) consistently outperform junk firms globally. A portfolio tilted toward these traits captured in the Quality-Minus-Junk (QMJ) factor recaptures significant risk-adjusted returns over time.
Additionally, in “What is Quality?”, empirical analysis verified that the quality premium is overwhelmingly driven by two categories: high return on capital (ROE, ROA, ROIC) and low capital reinvestment (firms that grow assets conservatively rather than aggressively diluting capital).