Counting On Quality With ETFs

Hallmarks of the quality factor, one of the most venerable investment factors, include identifying companies that grow earnings at impressive clips, pay and raise dividends and generated prodigious amounts of free cash.

Companies that fit the high quality label also sport stellar return on equity (ROE); with earnings season in full swing, now could be a good time for investors to consider the merits of the quality factor and exchange-traded funds that emphasize that factor, including the PowerShares S&P 500 Hgh Qlty Prtfl (ETF) (NYSE:SPHQ).

High-quality companies have characteristics that are attractive to investors, regardless of market cycles. They tend to generate strong return on equity (ROE) and throw off lots of free cash fundamental indicators of strength that set them apart from weaker competitors, said PowerShares in a recent note.

Return on equity is a barometer of how shareholders are rewarded for their invested capital with a higher number indicating a greater degree of profitability.

A Closer Look At SPHQ

SPHQ tracks the S&P 500 High Quality Rankings Index, which holds stocks reflecting long-term growth and stability of a company's earnings and dividends, according to PowerShares.

Quality Emphasis Pays Off

The ETF's emphasis on quality has paid dividends over time. Over the past three years, the $557.8 million SPHQ has returned 56.3 percent when factoring in paid dividends, beating the S&P 500 by 510 basis points over the period while being 140 basis points less volatile. With its quality emphasis, SPHQ should be less volatile than the broader market when volatility ticks higher and that has helped drive the ETF's performance.

In theory, high quality stocks should command premium valuations, and there are times when that is the case. However, SPHQ's index and its holdings are not currently richly valued.

The Quality And Value Relationship

Because they are able to generate high ROE and strong free cash flow, it would not be surprising to see stocks issued by quality companies priced at premium valuations, according to PowerShares. The S&P 500 High Quality Rankings Index is priced at 17.80 times earnings per share, compared with 16.99 for the S&P 500 Index. This 0.81 premium is almost right in line with the average seen since June 2011.

SPHQ Allocations

SPHQ holds 136 stocks, none of which account for more than 1.45 percent of the ETF's weight. Top 10 holdings include Dow components Nike Inc (NYSE:NKE) and Johnson & Johnson (NYSE:JNJ). Nike is SPHQ's largest holding.

Although it has been a laggard sector this year, industrials are SPHQ's largest sector weight at nearly 26 percent. Consumer discretionary, the best-performing S&P 500 sector year-to-date, is the ETF's second-largest sector allocation at a weight of 19.4 percent.

The S&P 500 High Quality Rankings Index is priced at 11.98 times cash flow compared with 10.49 times cash flow for the S&P 500 Index. The spread of 1.49 is below the 2.28 average seen since June 2011, according to PowerShares.

Disclosure: Todd Shriber owns shares of JNJ.

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