Paul: Welcome to Index Ideas, your fortnightly look at how FTSE Russell builds its indices and why. I'm Paul Amery, your podcast host. In this podcast, we explore how FTSE Russell Indices can help you solve real-world investment challenges, manage risk and capture new opportunities. As a reminder to listeners and viewers, you cannot invest in an index. And so the concepts that we discuss in the podcast are not investment advice. Our index ideas are for informational and educational purposes only.
Paul: In this episode, Matt Monach, who is a senior manager in FTSE Russell's equity quant research team, joins me to talk about a category of stocks with shared characteristics of strong profitability and low leverage. These are what we refer to as quality stocks. Matt, welcome back to Index ideas.
Matt: Very glad to be back. We definitely live in interesting times and the market looks very interesting.
Paul: Yeah. Great to have an opportunity to talk to you about this very topical subject. So, let's start with the definition. Matt, what is the quality factor?
Matt: Quality is the idea that some companies are better at generating strong and sustainable future cash flows than other companies. People often think of quality simply as buying good companies, profitable businesses with strong balance sheets. But from an investment perspective, we need to define that much more precisely. High profits alone aren't necessarily enough. We also want to understand how efficiently those profits are being generated, whether earnings are converting into cash and how strong the balance sheet actually is. So when I think of quality as asking a very simple question, how sustainable are the profits we observe today?
Paul: Great. Thanks for outlining that, Matt. So let's dig into some detail. How exactly does FTSE Russell measure quality?
Matt: At FTSE Russell, we use four measures. We don't use one single accounting measure. We look at the return on assets, which tells us how profitable the company is relative to the assets it's using. Change in asset turnover, which tells us whether those assets are becoming more or less productive. Accruals, which help us distinguish accounting earnings from cash generation, and a lot of my latest research was concentrating on accruals. And finally, operating cash flow relative to debt, which gives us balance sheet perspective. The first three form our profitability assessment. And the fourth adds the leverage. And if we combine those two, then we arrive at a composite measure of quality. So rather than defining quality using one single accounting ratio, we're looking at profitability operating efficiency, earnings quality and financial strength all together.
Paul: So Matt, thanks for explaining how FTSE Russell measures quality. Do other firms measure quality in the same way?
Matt: This is a great question. Quality is actually quite hard to define. It's very different to all the other traditional factors such as, for example, value or momentum, where people quite, quite often agree what the measures are to define a factor. And quality is a much more subjective measure because there are so many characteristics you could reasonably associate with high quality company. FTSE Russell's original research from 2015 looked at those characteristics empirically. High ROA and improved asset turnover were associated with stronger subsequent operating performance. High accruals were associated with historically weaker future profitability and cash flow relative to debt brought in a distinct balance sheet dimension. So we thoroughly tested our definitions, and they are published and ready for the viewers to inspect in detail. And just to conclude on the question. The important point is that the measures answer different questions. We aren't looking for four different versions of profitability. We are deliberately combining different perspectives on whether today's earnings are sustainable. That's also why I prefer a composite definition of quality to relying on one single metric.
Paul: Great Matt. Well, thank you for explaining that in such detail. So let's turn to a particular sector which is dominating the market for the last few years, the technology sector. Why have tech companies historically scored very highly on the quality factor?
Matt: So another great question because technology has been an almost ideal quality industry for much of the last two decades. These companies have generated extremely high profitability, particularly measured by return on assets. Many of the largest companies also combine strong operating cash flow with relatively strong balance sheets. And the economics of our industry helped. Highly scalable businesses could generate very large revenues and earnings without requiring the same physical asset base as traditional, let's say, industrial company would. In our data technologies, return on assets signal has been persistently stronger than that of the other industries. So there's a fundamental reason that quality portfolios have historically tended to find a lot to like in technology, so to speak.
Paul: Right. And that's recently changed, I understand from your recently published research. So what's changed?
Matt: It has changed quite a bit. The profitability hasn't disappeared. In fact, technology remains exceptionally profitable even compared to its own history. What's changed is the other side of the quality equation. Technology accruals have risen to their highest level in our roughly 20-year sample. So we have an unusual combination, exceptionally high profitability, but also an unusually large increase in operating and financial assets relative to cash generation. That is the interesting tension. It doesn't tell us that the profits are wrong, and it certainly doesn't tell us that technology is about to underperform. Although it can. It tells us that profitability and earnings quality are currently just sending different signals. And that is precisely the sort of situation where a multidimensional definition of quality becomes very useful.
Paul: So why are tech companies' accruals at such high and record levels?
Matt: A major part of the context is the substantial investment cycle currently taking place in the tech industry. If the largest tech companies are spending enormous amounts on data centres, servers, GPUs, networking equipment and all the associated real estate required to support the AI buildout, and in the FTSE Russell's accrual definition, changes in non-current operating assets are part of the calculation, so a major expansion of the asset base naturally matters. For perspective, several of the largest companies are now guiding to annual capital expenditure well above $100 billion, which illustrates the scale of the investment cycle. This is a scale unprecedented compared to the history, all of history. The important qualification is that high accruals do not automatically mean poor earnings quality. They can also arise because companies are investing heavily in long-lived assets. But the open question is what returns those assets ultimately generate.
Paul: And Matt, could you explain how concentrated the accruals are in the very biggest tech stocks? How concentrated are those accruals there?
Matt: This is a question on point. The short answer is very concentrated. This is unprecedented. This was actually one of the most interesting findings in the research that we did. If you look at the median technology company, it's accrual signal is much closer to the broader market. It's not really that much different. The main difference is when you weight companies by market capitalisation and then the picture changes dramatically. Roughly 60% of the technology's market cap is now represented by companies in the highest accrual decile. So this isn't a story about technology companies suddenly displaying very high accruals at large. It's primarily a story about some of the industry's largest companies. So we're talking mostly about tech mega caps that have been dominating not only the market but the news flow for several quarters, and that distinction between the number of companies and the capital represented by those companies is particularly important to index investors.
Paul: Right. So is it fair to say that if those large tech stocks generate very high cash flow in the next year or two and beyond, these measures will normalise? Or what would happen if they don't do so?
Matt: So this is a fascinating question. And I'm really looking forward to 2027 because everything should be revealed, so to speak, because this is very central tension now in the market. If the cash flows subsequently catch up with investment and revenues and earnings scale sufficiently against the much larger asset base, then today's higher accruals could prove to have been a sort of temporary consequence of a very large investment programme. And then everything is great, everyone's still making money in the market and everyone is happy. The accrual signal could then normalise and ROA could remain extremely strong. This is one of the scenarios. That's the optimistic scenario. This means that the infrastructure spending that we're currently experiencing right now was very productive and can continue to be rewarded by actual cash flows. But there's another possibility, which is slightly less optimistic. When the assets are being added today, regardless of how much revenue they eventually produce, if earnings and cash flow don't grow sufficiently, companies will be carrying a much larger asset base with greater depreciation and potentially weaker asset turnover, and then ROA will not be sustainable and could begin to fall, potentially quite substantially. So, in very simple terms, the cash flows now need to follow the investment and not only follow, they need to be large enough to justify the amount of capital that has been deployed. So personally, like I said, I'm really looking forward to 2027 because that will be very interesting. We did our research a while back. Now the podcast is recorded in mid-September. So, depending on when you tune into this podcast, the environment of technology might already be changing. So this is a very interesting space.
Paul: Right, so the question number one almost for the whole equity market.
Matt: Yes. Correct.
Paul: And have we seen similar market dynamics before amongst the technology stocks or for the quality factor? And if so, when and what happened next?
Matt: So there's actually an interesting parallel around 2012 to 2014. At that time, we also saw a strong concentration of technology market capitalisation among high accrual companies, roughly half of industry's weight at the peak. So not as high as today, but also very, very high. What followed was interesting from a factor Perspective, the companies with the strongest ROA had performed very well going into that period, but ROA factor subsequently weakened and underperformed. At roughly the same time, lower accrual companies, which had previously lagged, so previously was for the market not really important that some of those companies are loaded on accruals. They subsequently began to perform better and almost exact mirror image. But I would be very careful in terms of calling this a forecast, because the environment was completely different back then. Investors were emerging from the post-financial crisis period, while technology itself was moving from PC-centric sort of economics towards mobile, cloud and business platforms. So my phrase would be: history rhymes, but it does not repeat. The similarity is the tension between very strong current profitability and a technological transition requiring significant investment that is not yet confirmed by the cash flow.
Paul: Thanks for explaining that, Matt. Some very interesting parallels there. Just moving away from the quality factor for a second. How big a bet are investors in standard cap-weighted indices, such as the FTSE All World or the Russell 1000, placing on this particular cohort of tech stocks generating benefits from the current infrastructure spend?
Matt: So the first thing I would clarify is that capitalisation-weighted index isn't actively making an AI forecast of any kind. It is just representing the market. So it does exactly what's on the tin. But an investor tracking that index inherits the market's positioning and technology is now more than one third of FTSE Developed. And within technology, roughly 60% of market cap sits in that extreme high-accruals group that we mentioned earlier. Put those two observations together, and you get a sense of how economically significant this issue has become, but it doesn't mean one third of a portfolio is simply a sort of an AI bet. But it does mean that the return of a broad developed market portfolio, the returns are increasingly sensitive to whether a relatively small group of very large companies can convert unprecedented infrastructure investment mostly into AI, into future revenues, cash flows and returns on capital. I would describe it as an implicit exposure rather than an explicit investment view.
Paul: Right. And what can index users do if they would like to downsize such bets?
Matt: I think the starting point is not necessarily to remove the exposure. It is to understand it. A cap-weighted benchmark is doing exactly what it's supposed to do. It represents the market. So this currently is the market. However, investors then have to decide whether that's market concentration is appropriate for their objectives. There are several ways to change it. You can cap very large security weights. You can use a more diversified weighting scheme rather than allowing market cap to determine every weight. You can use equal weighting, although that introduces several additional exposures such as a substantial size tilt and exposure to liquidity or short liquidity. Or you can explicitly control industry and fact exposures. Or you can use indices such as RAISE, the Real Assets Industry Index, that concentrates on real assets segment of the equity market as a counterweight to technology. So there are many different approaches depending on the actual objectives of each individual or institution.
Paul: Great. And where can listeners and viewers go if they want to learn more about this topic?
Matt: So the starting point is FTSE Russell's article, "Quality Control: When Profits run ahead of cash". It's where we show the industry level profitability and accrual data, the concentration within technology and comparison with the 2012 and 2014 period. And for anyone who wants to go deeper into the methodology, I would point them to our website, which is full of resources and further research.
Paul: Thank you Matt. And that's it for this episode of Index Ideas. If you enjoyed the show, please follow us and like or share this episode on your podcast channel of choice. If you'd like to get in touch with us, you can do that via the email address
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