Robert Novy-Marx’s 2012 paper, “The Other Side of Value: The Gross Profitability Premium,” not only provided investors with new insights into the cross section of stock returns, it helped explain Warren Buffett’s superior performance—he bought value companies with higher profitability metrics.
Key Findings About Profitability
Novy-Marx’s study, which covered the period 1962 through 2010, used accounting data for a given fiscal year starting at the end of June of the following calendar year. Following is a summary of his findings:
- 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 valuation ratios that are significantly higher (for instance, a higher price-to-book ratio).
- Profitable firms tend to be growth firms—they expand comparatively quickly. Additionally, 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% per month higher than the least profitable firms. The data are 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% 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 increases the performance of value strategies, especially among the largest, most liquid stocks. Controlling for book-to-market ratio 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 actually are growth strategies.
- Because both the gross profits-to-assets and book-to-market ratios 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 that strategy’s overall volatility.
Explaining The Profitability Premium
Huijun Wang and Jianfeng Yu, authors of the December 2013 study “Dissecting the Profitability Premium,” sought to determine the source of the profitability premium—whether the explanation for it was risk-based or behavioral-based (in which assets are persistently mispriced).
A problem for risk-based explanations is that, intuitively, more profitable firms are less prone to distress and have lower operating leverage than unprofitable firms. These characteristics suggest that they are less risky.
On the other hand, more profitable firms tend to be growth firms, which have more of their cash flow somewhere in the distant future. More distant cash flows are more uncertain and should require a risk premium. Another risk-based explanation is that higher profitability should attract more competition, threatening profit margins. That too creates more risk and should require a risk premium.
To find their answer, Wang and Yu explored the role that systematic risk plays in the profitability premium, investigating its time-series variation. Previous studies have documented a set of macroeconomic variables that can predict the market risk premium. These macro variables include the default premium, the term premium, inflation, real interest rates and the quarterly consumption wealth ratio.
