A Closer Look at Factor Investing | Profitability Factor

A Closer Look at Factor Investing | Profitability Factor

By Brent Everett

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The third factor that we will examine is the profitability factor.  Quite simply, the stocks of more profitable companies have historically outperformed those of less profitable companies, despite having higher starting valuations.  The most notable research into profitability is attributed to Robert Novy-Marx at the University of Rochester’s Simon Business School.  Like value, profitability exposure helps to explain the performance of famous investors and practitioners, including Warren Buffett and Benjamin Graham.

We previously discussed the criteria for determining whether a factor is viable – namely, it must demonstrate persistence and pervasiveness, be intuitive or explainable in terms of financial/behavioral economics, and be investable.  Profitability is persistent.  In the U.S., high profitability stocks have outperformed low profitability stocks by an annualized 4.32% over the period from 1964 through 20161 and in 100 percent of 463 overlapping 15-year periods2.  The profitability factor is also pervasive.  In developed international markets, the stocks of more profitable companies outperformed less profitable stocks by an annualized 4.51% from 1990-20163.  We see a similar effect in emerging markets, where profitability outperformed by an annualized 5.21% from 1989-20164.

For our purpose, profitability is measured by the ratio of gross profits to assets.  The profitability factor can be explained by the tendency for profitable firms to grow quickly and to increase earnings, free cash flow, and dividend payouts.  From a risk-based perspective, highly profitable firms that are growing quickly tend to have more of their cash flow in the distant future.  This increases uncertainty. They may also attract more competition.

Gross profitability is easily measured and captured.  In addition, it is a low-turnover strategy.  In their study, “A Taxonomy of Anomalies and Their Trading Costs,” authors Novy-Marx and Mihail Velikov found this to be the case.

Thus, the profitability premium also meets our criteria for inclusion in client portfolios. Our preferred method of implementing profitability exposure in client portfolios is through the use of funds managed by Dimensional Fund Advisors (DFA), where it is used in core equity funds and layered into the construction rules of other funds, notably value. We prefer DFA’s implementation due to their track record of strong and consistent factor exposure, low expense ratios and tax efficiency.

Footnotes:

  1. Dimensional High Profitability Index minus Dimensional Low Profitability Index.
  2. High profitability is Dimensional High Profitability Index.  Low profitability is Dimensional Low Profitability Index.
  3. Dimensional International High Profitability Index minus Dimensional International Low Profitability Index.
  4. Dimensional Emerging Markets High Profitability Index minus Dimensional Emerging Markets Low Profitability Index.
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