Swedroe: Inside The Profitability Factor

December 02, 2013

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.

 

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
Price/Book 0.16 0.17
Price/Earnings 0.30 0.28
Price/Cash flow 0.25 0.25
Price/Sales 0.36 0.36
Multifactor 0.27 0.26

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.


 

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