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.
If the preceding market returns are driven by systematic risk, the intuition is that these traditional macro variables would have predictive power for the profitability premium. However, the authors found that macroeconomic variables showed little power to predict return spreads. In addition, they found that the profitability premium is mostly positive during recessions. Because most investors are risk averse, and a risk-averse investor requires large premiums for assets that perform poorly in bad times, their finding of outperformance during recessions is inconsistent with a risk-based explanation. We should expect to see premiums for owning assets that underperform, not outperform, during recessions.
The academic research has also documented that excess market returns (the beta premium) on macro news announcement days are about 10 times larger than returns on nonannouncement days, suggesting a disproportionately large fraction of risk premium on macro news announcements. Therefore, if the profitability premium is the result of compensation for macro risk, we would expect it to be larger on announcement days than on nonannouncement days. However, Wang and Yu found no such relationship. This evidence again suggests that traditional macro risk is unlikely to be the source of the observed profitability premium.
Other tests the authors ran did not find any systematic relationship between traditional risk measures and the profitability premium.
Searching For A Behavioral Explanation
Wang and Yu then turned to examining behavioral explanations. Their hypothesis was that, to the extent the profitability premium reflects mispricing, it should be larger among firms that are more difficult to arbitrage and have greater information uncertainty.
In other words, the greater the level of uncertainty, the greater the impact of investor overconfidence on prices we should expect to see. Where the limits to arbitrage are higher, mispricing is more likely to be sustained.
In addition, with greater information uncertainty, psychological biases are increased and information is more asymmetric among investors, leaving greater room for mispricing. Using a large set of standard proxies in the literature for limits to arbitrage and information uncertainty, the authors found that the profitability premium is substantially stronger among firms that are more difficult to arbitrage or have greater information uncertainty.
Specifically, they found:
- The profitability premium is insignificant or marginally significant among firms that have low information uncertainty and are easy to arbitrage.
- The profitability premium is about 1% higher per month among firms with smaller capitalization, a younger age, higher return volatility, higher cash flow volatility, less analyst coverage, larger analyst forecast dispersion, fewer institutional holdings, higher idiosyncratic return volatility, lower dollar trading volume, higher bid/ask price spread, lower credit rating and higher illiquidity.
- The majority of the profitability premium is derived from the subsequent low returns of the low-profitability firms. This is consistent with the notion that overpricing is harder than underpricing for arbitrageurs to correct due to greater shorting impediments.
- The profitability premium is not driven by ex-post overreaction (there is no evidence of long- term reversion) but by ex-ante underreaction. Investors underreact to the current profitability news, and hence high (low) profitability firms are relatively underpriced (overpriced).
Wang and Yu concluded that the profitability premium is unlikely to be driven by traditional macroeconomic risk factors. Rather, the premium persists because of limits to arbitrage, which prevents mispricing from being corrected.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.