Looking beyond the three-factor Fama-French may be just what your portfolio needs.
Our understanding of how the stock market works is ever changing.
The first model we had for explaining the returns of stocks was the capital asset pricing model, which was introduced in the early 1960s. CAPM was a single-factor model, with beta, or exposure, to the risk of the overall stock market being the factor.
About 30 years later, the Fama-French three-factor model was introduced. To beta, the Fama-French model added size—the return of small-cap stocks relative to the return of large-cap stocks, as well as value—the return of value stocks relative to the return of growth stocks. A few years later, the momentum factor was added.
The latest major advance was introduced by Robert Novy-Marx in 2012 in his paper, “The Other Side of Value: The Gross Profitability Premium.”
Marx showed that a simple quality metric—gross profits-to-assets—has about as much power predicting the relative performance of different stocks as do such value measures including price-to-earnings and price-to-book market.
Marx found that buying profitable firms yields a significant gross-profitability premium. He also found that a simple top-line measure of gross profitability, such as free cash flow or EBITDA, is a predictor of a firm’s future stock performance. In other words, profitability persists. The following is a summary of his findings:
- Strategies that exploit the quality dimension of value are nearly as profitable as traditional value strategies based on price signals alone.
- The quality premium is highly persistent and produces low turnover. Thus, it’s easily implementable in large-cap stocks.
- Accounting for both dimensions by trading on combined quality and price signals yields dramatic performance improvements over traditional value strategies.
- Accounting for quality also yields significant performance improvements for investors trading momentum as well as value.
One reason that combining the strategies adds value is correlation.
Specifically, signals in gross profits-to-assets and momentum are both negatively correlated with valuation ratios, and profitability and momentum have low correlation. Thus, they hold very different stocks.
For example, quality strategies tilt toward growth stocks. This makes quality strategies particularly attractive to traditional value investors, diversifying some of the risks of value strategies. The negative correlation results in smaller losses in downmarkets without sacrificing any of the premiums. It’s the negative and low correlations of the three factors that make a “core” approach (one that incorporates all three factors) so appealing.