It looks like portfolio construction is going to get a new set of blueprints.
The June 2012 publication of Robert Novy-Marx’s paper, “The Other Side of Value: The Gross Profitability Premium,” created quite a stir in the academic community.
The research has already begun to change the way funds are being constructed—at least those that are based on what might be called “the science of investing” or evidence-based investing—and how investors think about portfolio construction.
Fund families such as Dimensional Fund Advisors and AQR have created funds that incorporate Novy-Marx’s findings, and it seems clear that more fund families are going to be looking for ways to isolate this profitability factor in the design of future products.
To be totally clear about what’s happening, Novy-Marx’s findings can be summarized as follows:
- Profitability, as measured by gross profits-to-assets, had roughly the same power as book-to-market (a value measure) in predicting the cross section of average returns.
- Surprisingly, profitable firms generated significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios (higher price-to-book ratios).
- Gross profitability was a powerful predictor of future growth in gross profitability, earnings, free cash flow and payouts.
- Because both gross profits-to-assets and book-to-market were highly persistent, turnover of the strategies was relatively low.
- Because strategies based on profitability are growth strategies, they provided an excellent hedge for value strategies — adding profitability on top of a value strategy reduced overall volatility.
Max Kozlov and Antti Petajisto, the authors of the January 2013 paper “Global Return Premiums on Earnings Quality, Value, and Size,” investigated whether the return premium on stocks with high earnings quality was a global, and not just a U.S., phenomenon.
Their study covered the period July 1998-June 2012. The following is a summary of their findings:
- A simple strategy that’s long stocks with high earnings quality and short stocks with low earnings quality produced a higher Sharpe ratio than the overall market or similar strategies betting on value or small stocks.
- This result held both in the overall sample as well as in the more recent time period since 2005.
- Because the global earnings-quality portfolio had a negative correlation with a value portfolio, an investor wishing to invest in both exposures could have achieved significant diversification benefits.
- The results weren’t driven by hard-to-implement trades. Simple cap-weighted long-only portfolios with a combined value-quality tilt beat the broad market by 3.9 percentage points per year among large-cap stocks and 5.8 percentage points among small-cap stocks. Compared with a pure value tilt, the combined value-quality tilt added 1.2 percentage points per year among large-caps and 1.8 percentage points among small-caps.
The “out-of-sample” test suggests that Novy-Marx’s findings weren’t the result of data mining. Given these findings, it seems likely that more fund families will be developing product that will allow investors to access the profitability factor.
It will be important to see how this factor can be best included in the overall design of portfolios.