Swedroe: Accessing The Profitability Factor

Understanding the ways of getting at the profitability premium can help a portfolio in numerous ways, Swedroe says.

Reviewed by: Larry Swedroe
Edited by: Larry Swedroe

Understanding the ways of getting at the profitability premium can help a portfolio in numerous ways, Swedroe says.

A June 2012 study by Robert Novy-Marx, “The Other Side of Value: The Gross Profitability Premium,” provides investors with new insights into the cross section of stock returns. Among the important findings were:

  • Profitability, as measured by gross profits-to-assets—gross profits being sales minus cost of goods sold—has roughly the same power as book-to-market (a value measure) in predicting the cross section of average returns.
  • Surprisingly, profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios (higher price-to-book ratios).
  • Profitable firms tend to be growth firms—that is, they grow faster. Gross profitability is a powerful predictor of future growth in gross profitability, earnings, free cash flow and payouts.
  • The most-profitable firms earn 0.31 percent per month higher average returns than the least-profitable firms. The data is statistically significant (t-statistic of 2.49).
  • Controlling for profitability dramatically increases the performance of value strategies, especially among the largest, most liquid stocks.
  • 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.

Since the publication of that paper, we’ve seen mutual fund companies and ETF providers either develop funds that specifically target the profitability premium or incorporate the factor into their fund-construction strategies, by screening for stocks that load on the factor. Among fund providers doing so are Dimensional Fund Advisors (DFA), AQR, Barclays, iShares, FlexShares and Market Vectors. (Full disclosure: My firm, Buckingham, recommends DFA in constructing client portfolios.)

It’s important to note that the research has shown there’s a connection between the profitability factor and what’s called the “quality” factor. Quality stocks have features such as positive and stable earnings, low volatility and low leverage. However, just as there’s no single value definition, there’s no single quality definition.

The December 2013 study “Factoring Profitability,” which covered the period June 1963-December 2012, explored the connection using two factor models—the four-factor Fama-French-Carhart (FFC) model and Barra’s USE4 multifactor model.

The authors found that while the FFC model doesn’t provide a satisfactory replication of the gross profitability strategy, the Barra USE4 multifactor model did explain a substantial portion—more than two-thirds—of the gross profitability strategy with quality and momentum factors.

They also found that the book-to-market factor didn’t make a significant contribution to the gross-profitability strategy. However, they found that another value metric: earnings yield, did make a significant contribution to the gross profitability strategy.

This is consistent with other findings that show that value metrics other than book-to-market (such as price-to-cash flow) do provide exposure to the profitability/quality factor. This finding also provides support to the benefits of using multiple value metrics besides book-to-market in fund construction strategies.

Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.