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The case for the profitability factor in your portfolio

The profitability (or quality) factor boasts a number of traits that makes it particularly interesting for passive investors:

  • Profitability beat the market by 4% per year between 1963 and 2011.
  • It’s strong in large cap equities – a rare treat for a return premium.
  • It’s particularly powerful when partnered with investments in the value and small cap premiums because it’s negatively correlated with both.
  • Profitable equities tend to suffer less in a downturn than the total market.

Profitability works by concentrating on the firms that exhibit traits which are suggestive of rude business health in the future. It’s a bit like looking a potential mate up and down and determining their fitness according to the size of particular dangly bits. On an individual basis, you’ll often be disappointed, but apply the profitability criteria to enough candidates and on aggregate it seems to work.

The real power of profitability though may come from combining it in a portfolio with other financial steroids like value funds.

US Professor Robert Novy-Marx revived interest in the profitability factor with his work showing that a dollar invested in the US market in July 1973 grew to over $80 by the end of 2011.

But if you’d invested it in value and profitable equities instead, then that dollar would have grown to $572 (before expenses)

That’s a 615% increase.

Tempting.

The Holy Grail of diversification

Profitability works best in a multi-factor portfolio

The combination works because profitable companies are generally larger and more highly valued by book-to-market ratio than traditional value equities.

The outcome of holding them both is the holy grail of diversification: negatively correlated assets.

When profitable companies are on a roll, value firms tend to flop, and vice versa.

Bring together those complementary behaviours, and you have a portfolio that’s better able to resist a severe dip – because one of the factors should buffer you against the misfortune of the other.

This means you’re taking less overall risk in your portfolio, even though both factors are risky in and of themselves.

Big profits are beautiful

The large cap tilt of profitability also means it’s likely to bear up when small caps are going through a rough patch.

This is important for practical reasons, too. It’s hard for UK passive investors to invest in truly small cap equities. Most so-called small cap funds tend to invest more in mid caps, in reality.

Yet premiums like value, momentum and size are usually more powerfully present among smaller equities.

This means that while a return premium may deliver eyebrow-raising returns on paper, the reality of real-life investing is that those theoretical numbers can be leeched away if you have to invest in funds that don’t capture the most potent sources of return, such as micro cap equities.

Funds are also undermined by their management and transaction costs and their inability to easily short poorly performing equities, in comparison to the theoretical returns offered by the premiums as touted by academics.

Happily though, the paper Global Return Premiums on Earnings Quality, Value, and Size shows that a long-only portfolio1 can deliver strong returns by combining value and profitability.

This twin tilt beat the market by 3.9% among large caps, and 5.8% among small caps.

In comparison to a pure value tilt, the addition of profitability added 1.2% to the large cap returns and an extra 1.8% to small caps.

The effect becomes more pronounced still when you throw momentum into the mix, as this factor is negatively correlated with value and has a low correlation with profitability and small cap.

To actually invest in profitability check out our review of UK quality ETFs.

Take it steady,

The Accumulator

  1. That is, one that doesn’t short equities. []

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{ 18 comments… add one }
  • 1 old_eyes November 25, 2014, 11:24 am

    I think I understand what you and the paper are saying, but how does one execute in practice? Are there any funds that display this kind of focus? Or do you have to build it company by company, in which case how does it differ from a conservative high yield portfolio? I would guess that many suitable companies would be on someone’s wish list as high yielders.

  • 2 @algernond November 25, 2014, 11:33 am

    I’ve got Vanguard VWRL for all of my equities in my SIPP. I am wondering, does it not cover all of these factors (profitability, value, small etc..) ? Or is it that the proportions of them will not be correct?

  • 3 The Investor November 25, 2014, 11:36 am

    We’ll have an article on the practical options for passive UK investors looking for quality next week. 🙂

  • 4 rajkanwarbatra November 25, 2014, 12:11 pm

    So is this evidence in favor of active investing at least on a portfolio basis?

  • 5 Grand November 25, 2014, 2:37 pm

    Good stuff!

  • 6 The Rhino November 25, 2014, 3:16 pm

    Interesting series of articles from the Accumulator – I get the feeling he is building to a crescendo at which point a new era will dawn and it will become clear how to put all these tilts into practice to build a next-generation MONEVATOR uber-portfolio.. exciting times

  • 7 Lumino November 25, 2014, 3:45 pm

    Forgive me for what I guess is a dumb question… Negative correlation, is it really desirable? A perfect negative correlation between two asset classes would mean zero returns, no? Isn’t it uncorrelated assets that we actually want? Or are you relying on systematic rebalancing?

  • 8 magneto November 25, 2014, 5:27 pm

    @Lumino
    “Forgive me for what I guess is a dumb question… Negative correlation, is it really desirable? A perfect negative correlation between two asset classes would mean zero returns, no? Isn’t it uncorrelated assets that we actually want?”

    Not a dumb question. Have always found this issue perpelexing.
    If we had water in a U-Tube, and LHS rose 10% while RHS fell 10%, we would after one or more cycles still have the same amount of water (for water think money).
    Surely would be better if while LHS rose, RHS remained stable,
    I.E. some more water has to be added!

    What are we missing?

  • 9 Andy November 25, 2014, 10:49 pm

    @@algernond

    VWRL will contain profitable and value stocks, but not small since it is a large cap index. It will also contain unprofitable and growth stocks and every other type of stock with no particular weighting to anything other than market cap.

    It’ll be interesting to see what the practical options for UK investors are. I can’t really imagine, there is an iShares Quality Factor ETF, but I’m not sure if that is quite the same.

  • 10 Richard November 26, 2014, 12:42 pm

    @Magneto / Lumino

    I think that negative correlation helps reduce volatility rather than wipes out gain.

    If you had a profitable company that made umbrellas you’d do really well when it rained but not when the sun shone. Huge volatility…but still profitable over the business cycle, let’s assume.

    To reduce voliatility you want to make a produce that negatively correlates with umbrellas. So you make ice cream. When the sun shines you do well, when it rains you do not.

    Individually both these elements are profitable but volatile. Together they are equally profitable (over the business cycle) but much less volatile.

    At least that’s how I interpret it.

  • 11 The Investor November 26, 2014, 12:58 pm

    @All — Richard has it right. It’s about dampening volatility on the portfolio level, not negating expected returns from the constituents of the portfolio. (Diversification is never *ideal* in pure return terms because the best performing asset, if you only you could know it in advance, will beat a diversified portfolio where it’s held with others. But it improves your returns on a risk-adjusted (i.e. volatility) basis.)

  • 12 Rob November 26, 2014, 3:11 pm

    It would be interesting to see a model portfolio built to capture these factors. It’d take quite a while to work out if it consistently outperformed the slow and steady portfolio, or even just a Vanguard LifeStrategy fund.

    One thing to note about correlation – it measures direction and not magnitude. So it’s possible to have positive growth with -1 correlation, if the downward component moves in opposition to, but by a smaller amount than, the upward component.

  • 13 Gregory November 26, 2014, 4:02 pm

    It is very interesting that You do not use any factor in Your portfolio:
    http://monevator.com/the-slow-and-steady-passive-portfolio-update-q2-2014/

  • 14 The Investor November 26, 2014, 4:31 pm

    @Gregory — For the gazillionth time, that is not *his* portfolio. It’s a model portfolio, run as an example of simple self-managed passive investing. 🙂

  • 15 Ryan Turner November 26, 2014, 4:45 pm

    I gave the factor a spin using some commercial backtesting software in the Canadian market.

    As noted in the study, profitability as a single factor generates outperformance. Unfortunately, it appears to be completely explained by several other common factors such as E/P, ROE, and even price momentum. In other words, adding it to a model that already contains the aformentioned factors provides marginal benefits.

    Also worth noting is that the study tested the factor ex-financials which complicates its implementation in a balanced portfolio.

  • 16 The Accumulator November 29, 2014, 6:48 pm

    @ Old Eyes – I’d definitely use a fund but here’s a quote I found about picking stocks that exhibit gross profitability:

    “For each potential investment, you would need to subtract the company’s cost of goods sold from its revenue, then divide by its total assets.
    In general, says Mr. Novy-Marx, you want that ratio to be 0.33 or higher. You then would look for a low price-to-book-value ratio, available on most financial websites—ideally 1.7 or below. You would have to stick to big companies and diversify across many industries and dozens of stocks.”

    @ Algernond – VWRL is essentially the global market so the factor that influences it is beta. You only obtain factors like value, momentum etc by straining out the equities which exhibit negative loadings of those factors.

    @ Gregory – As The Investor says, the Slow & Steady portfolio is meant to be a very simple passive portfolio. Didn’t want to jazz it up with all kinds of factor flashiness.

    @ Raj – factor investing is a form of active investing in the sense that it means deviating from a purely passive take on the global markets and favouring certain equities that exhibit profitability or value or small cap etc characteristics.
    It’s not active investing in the sense of timing the market or picking individual stocks or claiming you know something others don’t.

  • 17 Gregory November 29, 2014, 7:30 pm

    @ The Accumulator – thanks Your reaction! In Europe Your blog is the most comprehensive investment blog for passive investors. And according to me the best here:) I’m from Hungary not UK but I have learnt a lot from the Monevator.com! And I hope I will lot more:)
    Have a nice weekend!

  • 18 The Accumulator December 3, 2014, 10:37 pm

    Thanks Gregory! I’m glad you enjoy the blog

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