Factor Primer Series: Profitability
As we ease into not only a new year but a new decade, we continue our series on factor investing (What is a Factor?; Small-Cap; Value; Momentum). Today, we dig into the profitability factor. As a reminder, we have defined factors as a source of excess return that is sensible, persistent over long time periods, pervasive across markets, and cost-effective to capture throughout this series.
What is the Profitability Factor?
The profitability factor is an almost laughably simple idea. If you are willing to believe it, more profitable companies have higher expected returns than less profitable companies! However, finding a reliable measure of profitability proved surprisingly difficult and it took until Professor Robert Novy-Marx’s seminal 2012 paper on profitability for a reliable metric to be identified1. Professor Novy-Marx found operating profitability (broadly speaking, revenue less cost of goods sold, interest expense and selling, administrative and general expenses). In simpler terms, it’s getting at a cleaner, less manipulated version of profits.
In some ways, the profitability factor is just another way to frame the Dividend Discount Model. The idea is that a stock should be valued at the sum of its current and future cash flows (defined by its dividend)2. This approach looked at the expected value of a stock in the hands of the investor, and profitability turns that on its head and looks inside the company at the company’s present and future cash flows as the determinant. Professor Novy-Marx’s research indicates that present profitability is a good indicator of future profitability. It’s kind of like predicting height. If parents are tall, there’s a good chance their kids are tall. Maybe even their grandkids. However, each generation ahead, the predictive strength diminishes.
How Does the Profitability Factor Provide Excess Returns?
Highly profitable firms outperform less profitable firms over long periods of time and do so very consistently. In looking at rolling 10-year periods of monthly returns, highly profitable firms (as defined as the most profitable 30% of firms) have outperformed less profitable firms an astonishing 91% of the 558 distinct 10-year periods between July 1963 and November 2019.
Profitability in a Portfolio
Profitability has shown itself to not just provide incredible consistency as demonstrated above, but also adds excess returns to a portfolio. From July 1963 through November 2019, highly profitable firms (the most profitable 30%) have returned nearly 11.5% annualized, where the market has returned approximately 10%. Less profitable firms have returned less than 8% in that same time frame.
Where profitability can be really powerful is in conjunction with the other factors. For example, when looking at a value stock, profitability can be a tool to weed out companies that are a value stock because their business is broken (i.e. sure, it’s a cheap stock, but it’s no longer profitable) versus a company that still has a good business (a profitable company and is on sale). Look forward to next month when we close out our Factor Primer Series by looking at how a multifactor portfolio adds value to your portfolio.
1-Novy-Marx, R. (2013). “The other side of Value: The gross profitability premium.” Journal of Financial Economics, Vol. 108, No. 1, pp. 1-28.
2- Gordon, Myron J. (1959). “Dividends, Earnings and Stock Prices”. Review of Economics and Statistics. The MIT Press. 41 (2): 99–105.
Chart source: Ken French Data Library. Profitability portfolios are constructed each month including NYSE, AMEX, and NASDAQ stocks with prior return data using the CRSP database. Portfolios are constructed using operating profitability. Operating profitability for June of year t is annual revenues minus cost of goods sold, interest expense, and selling, general, and administrative expenses divided by book equity for the last fiscal year-end in t-1. Highly profitable companies are defined as the 30% of companies with the highest operating profitability. Low Profitability companies are defined as the 30% of companies with the lowest operating profitability.
Jonathan S. Baker, JD, LLM, CPA, CFA is a Wealth Manager at BDF. Jonathan sits on the Investment Committee and contributes to developing BDF’s overall investment strategy. Jonathan received a JD and an LLM. in Taxation from the University of San Diego and double-majored in History and Economics at the University of Washington. Jonathan is a Certified Public Accountant, licensed attorney and Chartered Financial Analyst.