In previous blog posts I previewed several “factors” – characteristics of stocks – that can be utilized in portfolio construction to seek to improve equity (stock) returns over long periods of time (10-20 years) with a high degree of probability. In the April and May editions I explored the “size factor” – also known as the small cap risk premium or the small cap factor, as well as the “price factor” – also known as the value risk premium or the value factor. This month I explore the “profitability factor.”
History of the Profitability Factor
Academic researchers, armed with ever-greater computing power and much improved data sets on individual stocks, their historical returns, and the characteristics of various firms, have found a “zoo” of factors over the past three decades, although only several are robust and “investable.” As a result, the Fama-French 3-factor model [which contains the equity factor, the size (small cap) factor, and the price (value) factor] does not appear to fully capture all relevant factors that affect security returns, and that other factors beyond the three specified by Fama and French should be considered.
Novy and Marx (2013) found that in addition to the validity of the three-factor model, there is also a “profit expectation factor” which has a significant correlation with the expected value of stock return. Simply put, companies that possess high levels of profits, relative to the amount of assets the company possesses, tend to outperform companies with lower “profitability” ratios.
Profitability is measured by one or more of several different ratios derived from the financial statements of a company. These metrics include:
• gross profits-to-assets;
• net profits-to-assets, also referred to as “operating profitability”;
• return on assets (ROA);
• return on equity (ROE);
• return on invested capital (ROIC);
• and others.
The profitability factor might be summarized as follows: “A diversified basked of ‘high profitability’ common stocks possesses an 80% or greater probability of outperforming a broad market index over any given 20-year period of time.”
How Robust is the Profitability Factor?
It is quite robust. It has roughly the same power as the price-to-book ratio, a measure for discerning “value” stocks, in predicting the average returns of a diversified portfolio of common stocks over long periods of time.
Some academic studies have found that the profitability factor is a strong predictor of future stock returns in developed markets. However, the predictive power of the profitability factor appears to be weaker in emerging markets.
A recent study by Verdad, an asset management company, examined the quality factor (defined as gross profits-to-assets. Using this definition of quality essentially utilizes one method of constructing the profitability factor. The study broke down U.S. stocks by deciles (from “low profitability” to “high profitability”) for the period of June 1996 through June 2021, with annual rebalancing of the portfolios formed from each decile occurring each June. Stocks in the Russell 3000 Index, excluding financials and utilities, comprised the database, and microcap stocks (market capitalizations less than $300 million) were excluded. The study showed that the higher the tilting toward “profitability factor,” the greater the returns.
Source: Greg Obenshain, “How Does Quality Work”, VERDAD (October 4, 2021), using Capital IQ data for the period June 1996-June 2021. Past performance is not a guarantee of future returns. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.
In summation, the profitability factor, properly applied, can provide a high probability of superior returns over very long periods of time. It should be utilized in combination with other factors, in the design and construction of an investor’s portfolio.
Dr. Ron A. Rhoades serves as Associate Professor of Finance and Director of the Personal Financial Planning Program within the Gordon Ford College of Business at Western Kentucky University. He teaches and has taught courses in Retirement Planning, Applied Investments, Advanced Investments, Estate Planning, Financial Plan Development, Personal Finance, Money & Banking, Risk Management and Insurance, and Principles of Finance. He is regarded as a national expert in the application of fiduciary duties to the delivery of investment and financial planning advice. Ron’s upcoming book, Mastering the Science and Art of Investing: Strategies for Maximizing Returns with Multi-Factor Portfolios, is due to be published later in 2023.