Profitability is a viable investment factor, but questions remains on how best to isolate it.
A June 2012 study by Robert Novy-Marx, assistant professor of finance at the University of Rochester Simon Business School, "The Other Side of Value: The Gross Profitability Premium," prov0ided investors with new insights into the cross section of stocks returns.
Marx found that profitability was a highly effective predictor of relative returns across stocks. He also found that profitable firms generate significantly higher returns (0.31 percent per month) than unprofitable firms, despite having significantly higher valuation ratios, as measured by higher price-to-book ratios.
Another important finding was that because strategies based on profitability are growth strategies, they provide an excellent hedge for value strategies—adding profitability on top of a value strategy reduces the strategy's overall volatility. The question then is how to best integrate profitability into a value strategy.
Bridgeway Capital Management runs a family of mutual funds. Like the funds of Dimensional Fund Advisors (DFA) and AQR Capital Management, their investment strategies are based on a disciplined, statistical process, grounded in academic theory and objective data over long periods of time. (Full disclosure: My firm Buckingham recommends DFA and Bridgeway funds in constructing client portfolios.) At Buckingham, we use Bridgeway's Omni Small Value funds to gain exposure to U.S. small value stocks.
Bridgeway's research into combining value and profitability strategies in one fund found that its multifactor approach (price/book, price/cash flow, price/earnings and price/sales) provides greater exposure to gross profitability than a single-factor portfolio based on price/book.
In fact, Bridgeway found that the gross profitability exposure for each individual measure of value other than price/book was higher than it was for a price/book measure of value. As a result, constructing value portfolios using these other value metrics, in addition to price/book, naturally tilts a portfolio toward inclusion of more-profitable companies compared with using price/book alone.