When Quality is Salient: A Return-Based Approach for Uncovering Quality

We augment the standard market model for stock returns with firm quality as a latent variable to formalize the street wisdom that higher quality firms should perform better during relatively bad times. Consistent with our model, firms with superior performance during the worst month of a year are generally of higher quality according to commonly used measures. Furthermore, our model implies that winners in the price momentum strategy will, on average, be of higher quality, for which we find empirical support, thus establishing a commonality with quality investing. A long-short portfolio based on worst-month performance has a significant Fama and French (2015) five-factor alpha but has lower left tail risk when compared to commonly used pervasive risk factors and the momentum factor.