Swedroe: Digging Into The Profitability Premium

It has been well-documented that profitability is positively correlated with stock returns. Firms with higher profits earn higher returns. The profitability factor has also been shown to eliminate most of the well-known anomalies that can represent problems for the Fama-French four-factor model (i.e., returns that cannot be explained by exposure to the factors of beta, size, value and momentum). Thus, it has been incorporated into the newer factor models, including both the Fama-French five-factor model and the q-factor model.

Several papers have examined the issue of whether the profitability premium is the result of a risk premium or mispricing. Ryan Liu contributes to the literature on this subject through his November 2015 study, “Profitability Premium: Risk or Mispricing?”, which covered the period July 1963 through 2013.

Profitable Firms Outperform

Consistent with the prior research, Liu found that profitable firms have quite consistently outperformed the unprofitable firms (in 73% of the years in his sample) and have done so with lower return volatility, resulting in a higher Sharpe ratio.

While profitable firms have higher unconditional returns, investors might still avoid them if their returns are the lowest during bad times. Investors often care the most about returns during bad times, when their marginal utility of wealth is high.

However, Liu found that the premium is actually higher during economic downturns. Profitable firms do even better than the unprofitable firms during bad times, which, as we mentioned previously, is when marginal utility (the benefit of incremental income or wealth) is the highest. Thus, profitable companies are less susceptible to negative macroeconomic conditions—the profitability premium increases in recessions and when the stock market is doing poorly.

For example, Liu found that the worst one-year drawdown for the least profitable firms was -74%, nearly 30% worse than that of the most profitable firms. Liu concluded the evidence makes it hard to reconcile the profitability premium with a risk-based explanation, although it is consistent with persistent behavioral errors related to expectations.

A Mispricing Effect?
Liu then turned his attention to the mispricing hypothesis. Specifically, he examined the difference between earnings forecasted by sell-side analysts and actual earnings realized across profitability-sorted portfolios. If the low return of unprofitable firms relative to profitable firms was the result of investors being too optimistic about future performance, the difference between forecasted and actual earnings (the expectation error) should be larger for unprofitable firms.

Liu found a monotonically decreasing relationship across the 10 deciles of profitability from low to high. The expectation error was not only larger for unprofitable firms, it was persistent for up to five years. His investigation of the data led him to conclude investors expect the performance of profitable firms to mean-revert faster than they actually do, and they are willing to bet on the revival of the unprofitable firms despite low net income and poor current performance.

This is somewhat different from the more typical glamour story, in which naive investors become overly optimistic about the stocks in favor at the time because of good news or positive past performance.

But in this case, over-optimism is about the potential for mean-reversion of unprofitable companies, which tend to be newer, smaller firms in distress. Thus, these stocks tend to be overvalued. Due to limits on arbitrage, as well as the costs and risks of shorting, overvaluation is harder to correct than undervaluation.

While Liu found it difficult to reconcile the profitability premium with a risk-based explanation, it’s wholly consistent with the mispricing hypothesis. His findings are entirely consistent with prior research.

Other Explanations

In their January 2015 study, “The Profitability Premium: Macroeconomic Risks or Expectation Errors?”, F.Y. Eric C. Lam, Shujing Wang and K.C. John Wei explored alternative explanations for the profitability premium: a rational explanation based on macroeconomic risks and a mispricing explanation attributed to expectation errors.

The macroeconomic risk measures were related to industrial production, inflation, default risks and the term premium. The measure for expectation errors was based on an investment sentiment index that includes the following: average closed-end fund discount, number and first-day returns of IPOs, NYSE turnover, the equity share of total new issues and the dividend premium (the natural log of the difference in the average market-to-book ratio between dividend-paying stocks and nonpayers).

Their study, as we’ve previously discussed, included publicly traded firms (excluding financial and utility firms) in the Compustat database with fiscal years falling in a period that ranged from 1963 to 2010. Using three measures of profitability (return on equity, return on assets and gross profitability), the authors found:

• Gross profitability is the strongest predictor of future stock returns among the various profitability measures.
• The hedge portfolio of buying firms in the highest gross profitability quintile and selling firms in the lowest quintile generates a value-weighted average excess return of 0.31% per month (with a t-statistic of 2.16). The Fama-French three-factor alpha and the Carhart four-factor alpha are 0.55% per month (with a t-statistic of 4.49) and 0.50% per month (with a t-statistic of 4.34) per month, respectively. The equal-weighted average excess return, the Fama-French three-factor alpha and the Carhart four-factor alpha are 0.42% per month (with a t-statistic of 3.05), 0.40% per month (with a t-statistic of 2.99) and 0.35% per month (with a t-statistic of 2.96), respectively.
• Macroeconomic risks explain only about one-third of the profitability premium.
• Adding a misvaluation factor based on investor sentiment helps explain a large portion of the profitability premium. The equal-weighted and value-weighted return spreads between high- and low-profitability firms both become insignificant after controlling for the misvaluation factor.
• The profitability premium only concentrates in firms whose market valuations are inconsistent with profitability and therefore subject to ex-ante expectation errors.
• Firms with high profitability but low market valuation have significantly higher abnormal earnings announcement returns, analyst earnings forecast errors and forecast revisions than firms with low profitability but high market valuation.
• The profitability premium only exists during high sentiment periods for firms with ex-ante expectation errors.
• The profit of both the long leg and the short leg of the profitability strategy increases significantly with sentiment, suggesting that both undervaluation and overvaluation contribute to the profitability premium.

In the end, the authors concluded that their results suggest that misvaluation and its subsequent correction plays an important role in determining the profitability premium. It’s important to note that even though pricing errors—rather than a risk-based explanation—likely account for the profitability premium, its disappearance is not simply a foregone conclusion. Limits to arbitrage, which prevent mispricing from being corrected, can cause anomalies to persist.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.