Relative price and profitability effects in equity sector returns

In recent decades, empirical research conducted by Eugene Fama, Ken French, and others revealed that stocks with lower relative prices and higher relative profitability have generated higher returns over time.

These higher expected returns were persistent in the data over multiple time periods and pervasive across diversified equity markets around the world; however, investors might wonder whether these same factor-based phenomena have appeared at the sector level within a particular stock market. Dimensional analyzed 40 years of historical figures to help answer the question, and found that stocks characterized by low relative prices and high relative profitability do exhibit higher expected returns over time—regardless of the sector. These results may be useful to investors who are constructing factor-based portfolios at the sector level.

Marketwide dimensions of expected returns include relative price and profitability

Expected returns reflect the prices investors pay for a given asset and the cash flows they expect to receive from that asset. Controlling for expected cash flows, companies with lower relative prices—as measured, for instance, by the price-to-book ratio, or its inverse, the book-to-market ratio—should have higher expected returns than firms with higher relative prices. This is the value effect that has been well documented in the historical data at the broad market level. Controlling for relative price, companies with higher profitability—defined as operating income before depreciation and amortization minus interest expense scaled by book—should have higher expected returns than companies with lower profitability. This is the profitability effect that has also been well documented in the historical data at the broad market level.

Sector-level analysis affirmed the relevance of relative prices and profitability

But do these same phenomena appear at the sector level within a particular stock market? It turns out that the answer is, indeed, yes. Dimensional studied the relative price and profitability effects at the sector level using the sample period of July 1975 to June 2015, and sorted the largest 1,000 stocks within the U.S. market by sector. Next, within each sector, stocks were divided into two groups—one with low relative price and high profitability stocks and the other with high relative price and low profitability stocks—then market cap weighted the stocks in each group and computed their annualized compound returns. The analysis suggests that it is possible to pursue the value and profitability premiums at the sector level: In each of the industries and sectors in the sample, the portfolios with lower relative price (value) and higher profitability stocks outperformed the portfolios with higher relative price (growth) and lower profitability stocks. While the differentials varied from 1.84% (for healthcare) to 9.20% (for energy), they were all positive for the sample period.

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Positive implications for investors seeking factor-based sector portfolios

As it turns out, the relationships between relative price and profitability, on the one hand, and expected returns, on the other, are pervasive in the historical data. Strong relative price (or value) and profitability effects were observed not only at the marketwide level, but within narrower equity sectors as well. In our view, it is possible to target the value and profitability premiums at the sector level to create investment solutions that pursue higher expected equity returns using thoughtful design and efficient implementation.