The table below shows the average weighting on the profitability factor based on choosing the 20 percent of stocks based on the specific measure. The data is from CRSP as of June 30, 2013.
Weighted Average Exposure To Gross Profitability
|Value Measure||CRSP 6-10 Yrs||CRSP 7-10 Yrs|
It shouldn't be a surprise that stocks that exhibit value as defined by price/sales have the highest exposure to gross profitability, given the presence of sales in the numerator of gross profitability. All else being equal, as sales increase, so do both a stock's gross profitability and its value by sales/price.
Similarly, sales and cost of goods sold are more closely tied to accounting measures of value based on recent results such as earnings and cash flow, rather than with the balance sheet item book value. Thus, Bridgeway's finding of greater gross profitability exposure from a multifactor approach to value is intuitive.
Bridgeway also studied the alternative approach of using only the price/book value metric and adding a filter to screen out the least profitable stocks. Researchers at Bridgeway found that, to obtain the same exposure to the profitability factor as its multifactor approach, a fund would sacrifice a significant number of holdings, which would reduce the benefits of diversification and constrain the capacity of a fund.
Thus, they concluded that a multifactor approach to small value strategies—such as the one it uses—already benefits substantially from the profitability factor.
The upshot of all this is that it's probably safe to say that given the importance of Novy-Marx's findings, we are likely to see more research into how best to incorporate gross profitability factor into fund construction rules.
Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.