Profitability: Entering a New Dimension?

Investors should always be skeptical about new strategies that promise abnormal returns. As I explained in last week’s post, some of those strategies are dubious to begin with, and even legitimate ones don’t always last.

But that’s not to say academic research can’t shed light on how markets work. Indeed, the Fama-French three factor model, described in a landmark 1992 paper, reveals how small-cap and value stocks offer additional risk premiums that have become the specialty of Dimensional Fund Advisors.

Now there’s new research that may prove equally influential. In The Other Side of Value: The Gross Profitability Premium, Robert Novy-Marx of the University of Rochester argues that “profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market predicting the cross-section of average returns.”

As you can tell, the paper is rather technical, but here’s the basic idea. It’s rational to expect higher returns from cheap value stocks, since they are inherently riskier. It is harder to explain why profitable companies would reward investors when they trade at higher multiples and are less prone to distress. Yet Novy-Marx found that profitable companies actually performed about as well as value companies. (For more, see Larry Swedroe’s summary of the paper’s findings.)

Playing for all the marbles

I first heard about this idea from Art Johnson, a portfolio manager with Scotia McLeod in Calgary and one the early pioneers who adopted DFA in Canada almost a decade ago. Johnson feels that a profitability screen will take the Fama-French research to the next level. Here’s how he describes the significance:

“The value factor measures the number of assets you receive relative to the price of the stock. So think of a game of marbles: tilting to value stocks is really saying if I have more marbles (assets) than you, I believe I will win in the end. The way we identify the number of marbles we’re buying is by using the book-to-market ratio.

“The problem with this strategy is it’s risky. In order to get more marbles I have to trade with someone in trouble who is willing to surrender them. And I don’t know if these are good marbles, I just know I have more of them. We can partly overcome this through mass diversification: companies like DFA buy thousands of marbles (value stocks). But the exciting thing is that academics now seem to be making headway into measuring the quality of those marbles.

“Now we can think about a method whereby we’ll not only have more marbles than the other guy, but we’ll also be able to sort them based on how good they are. This is a big deal: before this work, you could argue we only had half the puzzle solved. We knew where we could take more risk, but now this allows us to sort through companies and only retain the most profitable ones.”

Low correlation with value

The other promise that comes out of Novy-Marx’s paper has to do with the relationship between value and profitability premiums. As the author writes: “Strategies based on gross profitability generate value-like average excess returns, even though they are growth strategies that provide an excellent hedge for value.”

In other words, the two strategies not only deliver similar returns, each tends to zig when the other zags—and negative correlation is the Holy Grail of diversification. “This means you can run them in tandem,” says Johnson, “and since they are separate risks, you actually end up lowering volatility and enhancing returns.”

What is the main risk of the profitability factor? Imagine buying highly profitable companies and shorting those with low profitability, a hypothetical strategy reviewed in the paper. “Think of how that would have worked in the tech bubble,” Johnson says. “You would have been shorting very unprofitable tech stocks that kept going up, while buying value and profitable companies [that lagged significantly]. Ouch. So there is no free lunch.

“Our knowledge of how you can be paid for being different from the total stock market has just undergone a massive expansion because of this work,” Johnson says. “Just be cautious, and be sure you know what the risks are before you naively see only the reward.”