Swedroe: Exploring The Profitability Factor

A June 2012 study authored by University of Rochester professor Robert Novy-Marx, “The Other Side of Value: The Gross Profitability Premium,” not only provided investors with new insights into the cross section of stocks returns, but also led to the development of new factor models that incorporate a profitability factor.

Novy-Marx’s Findings

Before unpacking a more recent paper with new insights into how accruals and cash flows can impact profitability, I think it’s important to summarize some of Novy-Marx’s more fundamental findings on this premium:

• Profitability, as measured by gross profits-to-assets, has roughly the same power as book-to-market ratio (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 (for instance, higher price-to-book ratios).
• Profitable firms tend to be growth firms—they expand comparatively quickly. Gross profitability is a powerful predictor of future growth as well as of earnings, free cash flow and payouts.
• The most profitable firms earn average returns 0.31 percent per month higher than the least profitable firms. The data is statistically significant, with a t-statistic of 2.49.
• The abnormal return (alpha) of the profitable-minus-unprofitable return spread relative to the Fama-French three-factor model is 0.52 percent per month, with a t-statistic of 4.49.
• The returns data is economically significant even among the largest, most liquid stocks.
• Gross profitability has far more power in predicting the cross section of returns than earnings.
• High asset turnover primarily drives the high average returns of profitable firms, while high gross margins are the distinguishing characteristic of “good growth” stocks.
• Controlling for profitability dramatically raises the performance of value strategies, especially among the largest, most liquid stocks. Controlling for book-to-market improves the performance of profitability strategies.
• While the more profitable growth firms tend to be larger than less profitable growth firms, the more profitable value firms tend to be smaller than less profitable value firms.
• Strategies based on gross profitability generate valuelike average excess returns, even though they are actually growth strategies.
• Because both gross profits-to-assets and book-to-market ratio are highly persistent, the turnover of the strategies is relatively low.
• Strategies built on profitability are growth strategies, and so they provide an excellent hedge for value strategies. Adding profitability on top of a value strategy reduces the strategy’s overall volatility.

The Accrual Anomaly

Ray Ball, Joseph Gerakos, Juhani Linnainmaa and Valeri Nikolaev, authors of the April 2015 University of Chicago working paper “Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns,” provide some additional, and important, insights into the profitability factor.

They observe that profitability includes accruals (adjustments accountants make to operating cash flows to measure earnings) that, when added to cash flows, provide a better measure of current period performance.

This improved measure works because, as the research shows, there’s a strong negative relationship between accruals and the cross section of expected returns. This relationship is known as the “accrual anomaly.” It isn’t explained by current factor models, including either the Fama-French five-factor model or the q-factor model proposed by Kewei Hou, Chen Xue and Lu Zhang.

The University of Chicago working paper covers the period July 1963 through December 2013. Following is a summary of the authors’ findings:

• Cash-based operating profitability devoid of any accounting accrual adjustments outperforms other profitability measures, including operating profitability, gross profitability and net income.
• Cash-based operating profitability produces an average annualized return of 4.8 percent compared with 3.5 percent for operating profitability. The t-stats were 6.3 versus 4.0, respectively.
• Any increase in profitability solely due to accruals has no relation with the cross section of expected returns.
• Cash-based operating profitability performs so well in explaining the cross section of expected returns that it subsumes the accrual anomaly. Investors are served better by adding only cash-based operating profitability to their investment opportunity set than they are by adding both accrual and profitability strategies.
• Cash-based operating profitability explains expected returns as far as 10 years ahead, suggesting that the anomaly isn’t due to initial earnings mispricing or its two components: cash flows and accruals.

The authors of the paper concluded: “Taken together, our results provide a simple and compelling explanation for the accruals anomaly. Firms with high accruals today earn lower future returns because they are less profitable on a cash basis.”

Profitability In Practice

It’s interesting to note that, in implementing the profitability factor, AQR Capital Management uses three measures of profitability (total profits-to-assets, total profits-to-sales, free cash flow-to-assets) in its multistyle funds. Aside from profitability, the other two factors in their multistyle funds are value and momentum.

Similarly, AQR doesn’t solely use the single screen of book-to-market (BtM) ratio to select value stocks. In addition to BtM, it uses the following four metrics: price-to-earnings, price-to-forecasted earnings, market cap-to-free cash flow from operations and sales-to-enterprise value.

Other value managers, including Bridgeway Capital Management and firms using the Fundamental Index benchmarks, also incorporate cash flow metrics into their fund construction rules.

Doing so provides them more exposure to the profitability factor than a single BtM measure, and is, in effect, incorporating the information about cash flow into the strategy. (Full disclosure: My firm, Buckingham, recommends Bridgeway and AQR funds in constructing client portfolios.)

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