Using the profitability factor in multifactor investing

When it comes to factor investing, many investors are familiar with the documented outperformance of small-cap and value stocks. Yet more recently, researchers have uncovered another factor: profitability, which research has shown may complement and enhance other factors to complete a multifactor strategy.

Using the profitability factor in multifactor investing

During the period from 1964 to 2018, high profitability companies have averaged annual returns of 11.30%, compared with 7.87% for low profitability companies, as shown in the figure below. The idea is that presently profitable companies tend to continue to be more profitable in the future, and are rewarded by the market with better stock performance. This makes sense because highly profitable companies tend to be good stewards of investor capital and also tend to pursue projects with profitable outcomes.

Factor premiums by size, value and profitability

Research in recent years from Dimensional Fund Advisors and others has documented that profitability is indeed a factor, or a characteristic that conveys information about expected returns.¹

How to measure profitability

There are many ways to measure profitability. For example, investors could look at sales, net operating income, and net income.

Essentially, profits are revenues minus expenses. However, academic research shows that not all current revenues and expenses contain the same amount of information about future profits.² The research also shows that it makes sense to strip out one-time, “extraordinary” revenue or expenses that may not persist in the future.

The equation that Dimensional in particular uses for what it calls direct profitability is somewhat complex at first glance.³ It can be broken down as: 

Profitability = sales - cost of goods sold - selling, general, and administrative expenses / book equity 

Book equity is simply what a company owns, minus what it owes. 

In accounting terms, the equation above looks like this:

Profitability = operating income before depreciation and amortization - interest expense / book equity

Put simply, the ratio is designed to identify companies with highly profitable and productive assets. Direct profitability might also be thought of as “top-line” profitability that removes many expenses. Research from Dimensional shows the profitability premium is persistent through time, and in markets outside the U.S.⁴

One question we hear a lot is the difference between profitability and “quality,” which is often classified as a factor. Although there is no universal definition of quality, it typically includes profitability as well as other metrics that focus on the balance sheet, such as corporate debt and leverage. From a portfolio-implementation perspective, defining factors as simply as possible may help with stability and lessening turnover. This is why profitability may be preferable to quality.

Pairing profitability with value

It makes economic sense why highly profitable firms would be consistently rewarded by investors. Also, it turns out that pairing the value factor with profitability may lead to better investment results.

How do value and profitability work together? Remember, value stocks are those with lower relative prices, measured by price-to-book value. One of the main risks of value investing is that the company is cheap for a reason–also known as a value trap. Adding profitability to the value factor may help investors avoid value traps by seeking to identify higher-quality companies.

Conversely, one of the main risks of buying highly profitable companies is to overpay. However, incorporating a value or relative-price screen may help investors avoid highly profitable companies that are expensive. Putting it all together, adding profitability to other factors such as size and value may improve risk-adjusted returns as well as overall portfolio diversification.   

 

 

“The Other Side of Value: The Gross Profitability Premium,” Robert Novy-Marx, Journal of Financial Economics, vol. 108 (2013), 1–28. 2 "Evolution of Financial Research: The Profitability Premium," Dimensional Fund Advisors, April 2017. 3 "Expected Profitability: A New Dimension of Expected Returns," Dimensional Fund Advisors, May 2013. 4 "Evolution of Financial Research: The Profitability Premium," Dimensional Fund Advisors, April 2017.