The Lighter Side Of The Profitability Factor

June 16, 2015

Many investors have been getting excited about the so-called profitability factor, originally posed by Novy-Marx. It’s worth looking at it more closely, as not all is necessarily as it seems.


The basic idea is simple: Other things being equal, firms with high gross profits (revenue costs) have earned higher expected returns than firms with low gross profits.


Even market heavyweights Eugene Fama and Ken French have integrated the factor into their new "5-factor model," which consists of a market factor, size factor, value factor, profitability factor and an investment factor.


This research was not lost on Dimensional Fund Advisors (DFA), a quantitative asset manager that’s essentially an extension of the University of Chicago Finance Department. DFA has added the concept of profitability to its process (we assume it is the profitability factor identified by Fama and French).


In the words of Eduardo Repetto, DFA's chief investment officer, regarding profitability:


“New research has to be very robust, very reliable, and have real information that's not already captured in the other dimensions.”


Research On Profitability

But how robust and reliable is the so-called profitability factor, and is it possible that it might already be captured in other dimensions?


new paper titled, "A Comparison of New Factor Models," by Kewei Hou, Chen Xue and Lu Zhang, shows that the profitability factor is not, in fact, a new "dimension," as has been suggested.


The authors find that the profitability factor highlighted by Fama and French is captured in cleaner ways by their simpler and more robust four-factor model, which consists of a market factor, a size factor, an investment factor and a return-on-equity factor.


Outstanding Concerns

The authors highlight that there are "four concerns with the motivation of the Fama and French model based on valuation theory," suggesting that the factors chosen by Fama and French are merely descriptive and/or data-mined, but not grounded in economic theory. Ouch.


But the critique of the five-factor model isn't only on theoretical grounds. It is also based on the evidence. The Hou, Xue and Zhang four-factor model captures all the returns associated with the new factors outlined by Fama and French. This suggests that the "new" profitability factor may not be a new dimension at all, since it can be explained via exposures to the market, size, and Hou, Xue and Zhang's investment and ROE factors.


Profitability is also questionable in international markets.



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