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The profitability factor – surely there’s a catch?

Continuing our voyage to the outer limits of the passive investing universe, it’s time to probe another of the return premiums – those strange and mysterious wonders of the financial medium that can power your portfolio like a rocket ship.

One of the more potentially potent of these energy sources is the profitability factor, otherwise known as the quality factor.

Few Earthlings will be surprised to learn that profitable companies are a good investment. But the real breakthrough came with the discovery that profitable companies beat the market by 4% per year between 1963 and 2011 – even despite their higher valuations.

In other words, if you can uncover wonderful companies that are cheap at the price, then you can potentially skim off a return premium that’s as strong as the value factor.

The secret is to find the companies that will be profitable in the future and avoid the ones that won’t.

Enter Professor Novy-Marx. Like an old space prospector searching for precious minerals in the asteroid belt, Novy-Marx has seemingly identified a key marker of success – gross profitability.

Ooh, gross

Gross profitability is the ratio of a firm’s gross profits1 to total assets. Gross profit is a measure you’ll find near the top of a public company’s income statement.

If a company’s sales far exceed the costs of making those sales (such as the drag of raw materials, overheads, and employee wages) then its gross profit will be strong and likely to persist in the future.

Most investors judge companies on net profit after deductions for R&D, advertising, depreciation and so on. That means that heavy investing in brand-building and innovation can make a company look less profitable in the short-run.

Yet those are precisely the moves that reinforce a company’s capacity to compete in the future.

Profitable companies invest more today

The insight of gross profitability is that it doesn’t knock out companies that are making long-term investments in favour of competitors who look profitable now because they are skimping on tomorrow.

Amazon is a classic example of a company that’s delivered mediocre net earnings because it’s spent billions on enough drones, robots and other assets to try to own the future. Its profits look far healthier when unmarred by this spending that may yet enable the retail giant to lay waste to the competition in the years ahead.

But perhaps drone deliveries are a flying white elephant?

Therein lies the risk, and the possible seeds of an explanation for the premium.

How can profit be risky?

Why should profitable firms offer a greater return than unprofitable ones? Surely it should be the other way around, as we expect bigger carrots to be dangled for taking on bigger risks?

Theories abound. Perhaps profitability is riskier than it seems because:

  • Highly profitable firms attract competitors, like young lions might get their paws first on a gazelle but are quickly shouldered aside by their bigger relatives. In other words, competitors soon move in, profits deteriorate, and your investment loses value.
  • Profitable firms must be highly efficient. They must wring the most out of their servers, factories and employees before replacing them apace as their market develops. If they invest in the wrong assets then they’re likely to be outperformed by rivals who’ve better called the changes.
  • Profitable firms are likely to be growth firms. Thus more of their worth relies upon the swelling cash flows of their dazzling future. That makes them risky in comparison to low profitability firms, whose value is based on dismally low expectations.

Think of the spread of risks as similar to betting on whether the talented school football captain will play for England versus whether the school psycho will go to prison. Psycho is more likely to fulfil expectations.

In addition, most return premiums exist at least in part because of flaws in investor behaviour that humanity finds tough to rectify.

So it’s entirely possible that profitability endures because investors tend to underweight positive changes in company fundamentals.

User warning

The nerve-racking thing about the return premiums is that although they offer the prospect of beating the market, there is a chance that the good times may never materialise.

If the profitability premium simply owes its existence to behavioural flaws then those flaws may be arbitraged away.

By contrast, risk persists – but isn’t certain to pay off. Just like the general stock market might flatline for 20 years, any of the return premiums could fail to deliver for years and years on end.

All the same, profitability has a number of exciting features that make it particularly enticing for anyone who’s already decided that the return premiums belong in their portfolio.

And if you’re already convinced of the case for profitability then take a look at our review of the UK’s quality factor ETFs.

Take it steady,

The Accumulator

  1. That is, sales minus cost of goods sold. []

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{ 9 comments… add one }
  • 1 moneystepper November 18, 2014, 11:58 am

    Intriguing.

    Regarding investing in the future, do you know of any studies done which compare the amount of PBT spent on R&D for public companies compared to their future returns?

    I find it fairly intuitive that profitable companies lead to better returns, but I wonder if there is any metrics that can be used to determine the potential future profitability of different companies/sectors/etc…

  • 2 Mr Zombie November 18, 2014, 12:14 pm

    Hi,

    Interesting read 🙂

    Is the gross profit premium because investors want profits and dividends now and not in the future or because the market discounts the future benefit of R&D etc due to its uncertain effects on future profits?

    You say “If the profitability premium simply owes its existence to behavioural flaws then those flaws may be arbitraged away.” Could you explain this? I’m struggling to undertand arbitrage in this sense!

    Thanks

  • 3 rajkanwarbatra November 18, 2014, 2:20 pm

    Makes sense. Below the line items are more easy to control and defer in time of trouble and racket up to get market share in good times.

    On the other hand if business has low gross margin than it is a marginal business to start with and over a period of 40 years would more likely wither and not grow or die.

  • 4 grlla November 18, 2014, 2:43 pm

    Is this leading us to the Quality Street, I mean Mix, index and the recent ETFs following it? It’s an intriguing blend, though I am still a bit sceptical about ‘smart beta’, especially in such early days.

    Talk of profitability also reminds me, in the Active world (forgive me) of Nick Train’s optimistic belief in the right profitable companies, even when fairly pricey.

  • 5 qpop November 19, 2014, 3:38 pm

    There’s a great article by Tim Harford which is relevant to this – Finance’s “Jelly Bean Problem” http://timharford.com/2014/11/finance-and-the-jelly-bean-problem/

  • 6 grey gym sock November 19, 2014, 10:39 pm

    this is all much newer theory than most of the other “factors”. which is 1 reason to be cautious.

    even if you want to use it, you may not want a fund targetting “profitability” by itself. the overall theory might be that returns are explained by the combination of about 5 factors (which might be: “market”, “size”, “value”, “momentum”, “profitability”) – or perhaps fewer or more than 5 – it doesn’t seem to have settled down. but “profitability” is only going to explain a relatively small part of returns.

    funds that choose which companies to hold based on some combination of factors are a possibility. there is even the suggestion that a combination of “profitability”, “value”, and so on, might roughly duplicate warrren buffett’s method: http://www.etf.com/sections/index-investor-corner/21477-swedroe-unpacking-buffetts-genius.html?fullart=1

    as with other factors, presumably in order to fully exploit it you need both to buy shares with high “profitability” and to short-sell shares with low “profitability”. which would require a slightly different kind of fund.

    i don’t know if any suitable funds (of any type) exist yet.

  • 7 The Accumulator November 20, 2014, 9:40 am

    @ Mr Zombie – if someone discovers that human beings are undervaluing or overvaluing a particular asset then there’s money to be made by taking a position on the other side of the deal. So if I know that everyone’s going mad for overvalued tech stocks then I’ll sell or short-sell as many as I can and earn a handsome profit. However, all that furious buying is going to raise the price of the stocks to the point that demand is choked off. At that point I’ve arbitraged away the mispricing. There’s no more profits for anyone else to make from the mania that caused the tech stock bubble.

    Theoretically any human behaviour that contributes to mispricing can be exploited up to the point where everyone realises they’re being exploited and changes their behaviour. But certain behaviours seem to persist across time, geographies and asset classes – as with the momentum factor and the behavioural explanations of the value factor.

    @ Old Grey – Multi-factor funds seem to be the way to go but there aren’t any good options yet. I totally agree with your dream combo of factors.

    As a rough rule of thumb, long only funds will capture about 50% of a factor. Long-short funds don’t exist in the UK and even in the US they’ve only just emerged via a company called AQR.

  • 8 Ed Croft November 21, 2014, 5:43 pm

    Sorry to be critical, but why on earth do we always have to figure out what the ‘risk’ being paid off is when we find a strategy with a higher return?

    Surely it’s common sense to realise that there is a negative payoff to risk. High risk stocks are priced like lottery tickets, with negative aggregate payoffs. Just have a look at how the FTSE AIM market has done in the last decade against the FTSE 350 and it’s pretty clear there’s been no payoff to most of the junk listed there. It’s been the same with OTC stocks in the USA etc.

    Unfortunately everyone is so enamoured with the idea that return and risk are positively correlated that they fail to look at reality. There’s a marvellous book by the heretic Eric Falkenstein which illustrates beyond doubt that there’s no payoff to risk. Low-volatility (low-risk) investing is now in the ascendancy as an approach which, ironically, beats the market.

    So I pose the question, what’s the higher ‘risk’ being paid off for the higher returns generated by a ‘low-risk’ portfolio? Has the world gone mad or does the emperor have no clothes?

  • 9 Mr Zombie November 25, 2014, 4:31 pm

    Thanks, I get it now. I was thinking of being in an ‘undervalued’ asset already. It that was then arbitraged away it would be happy days 🙂

    Mr Z

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