Direct Profitability—an Added Dimension of Small Cap and Value Investing


Profitability Painting

In a prior article, we introduced a new measure of expected future profitability (current direct profitability1) and discussed the possible modification of the Fama/French three factor asset pricing model to incorporate this fourth factor. In this article, utilizing research2 from Dimensional Fund Advisors, we will take a deeper look at the impact of incorporating direct profitability into the construction of value-tilted and small funds. We will analyze large cap stocks separately from small cap stocks.

When determining whether a particular stock is a value stock, the parameter we use is the ratio of book-value to market-value (BTM). Recall that book value can be thought of as the value of the company that its accountants would assign to it, while the market value is simply the share price multiplied by the number of outstanding shares. For the purpose of this analysis, four portfolios were constructed:

1)     A large value (without profitability) index comprising the top 25% of BTM within the top 90% of market value

2)     A large value (with profitability) index comprising the top 30% of BTM within the top 90% of market value and with heavier weightings of stocks with higher direct profitability

3)     A small value (without profitability) index comprising the top 25% of BTM within the bottom 10% of market value

4)     A small value (with profitability) index comprising the top 35% of BTM within the bottom 10% of market value and with heavier weightings of stocks with higher direct profitability

Note that once profitability is introduced as a construction factor, we are able to relax the BTM constraint, which means that the value funds will have less tracking error relative to the overall market.

The chart below summarizes the results over the 34-year period ending 12/31/2012.

As you can see in these simulations, there would have been a direct benefit to returns without incurring the usual cost of higher volatility (standard deviation). For large value, the additional annualized return was about 0.6% per year, and for small value, it was about 0.4% per year. This may not seem like much, but over a 30-year period, the growth of $100,000 at a 10% compounded rate would be increased by $225,000 with an additional 0.5% of return. Although small value would have benefited less than large value from profitability on an absolute return basis, it actually would have benefited more on a risk-adjusted basis.

One of the primary requirements of a potential dimension of expected return is that it shows up on data that is outside of the initial sample. In this case, the out-of-sample data is from the international developed countries. The two charts below show the results for four international value indexes constructed similarly to the four U.S. value indexes.




According to these simulations, direct profitability appears to have been a robust dimension of expected returns and it offers a definite potential benefit to investors in small cap and value-tilted funds.

Recently, there have been some concerns and questions about expected profitability as a dimension of expected returns. The crux of one person's concern centered around the Dividend Discount Model. This model basically states says that the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. The simplified formula of the model states that Market Value = Future Cash Flows/Expected Return.

While Fama suggested holding the market value or capitalization constant to compare companies of similar market cap, this person thought he meant the market cap of one company was to be held constant and therefore said that the price can never be held constant while future income and expected return both change. This person contended that when the market perceives that the expected future income of a company has increased, the share price should increase accordingly. We believe that there was a misconception about "holding price constant." Instead, we believe Fama was saying that if we looked at a group of small market cap stocks, with different incomes or gross profitabilities, then the expected returns must be different. Using two actual small cap companies may help in understanding the concept:  

Let's hold the "price constant" by looking at two small capitalization companies, Domino's Pizza and Cymer, Inc., each with the same market capitalization of about $3.7 Billion. Let's assume that Domino's Pizza has gross profits (net of interest) of about $500 million and Cymer has gross profits (net of interest) of $220 million. If the two companies are valued the same at $3.7 Billion, the prices set by buyers and sellers (the market) may have assumed that the future gross profits of Domino's Pizza are less certain or may grow at a slower rate than Cymer and therefore Domino's expected gross profits would be considered riskier. Higher risk would indicate that the required rate of return for the investor, otherwise known as the expected return of Domino's Pizza, might be higher by 1.5% annualized (just as an example) than Cymer, since risk and expected return are positively correlated.

Critics of profitability acknowledge that higher current profitability has been associated with higher subsequent returns (particularly when controlling for small cap and value exposure), but offer no explanation for why the higher returns which occurred in the past cannot be expected to continue in the future. By the same token, the critics accuse the advocates of profitability of failing to offer an adequate reason why the higher returns should be expected to continue. The truth is that nobody can nail down for certain what information and forecasts are embedded in prices and exactly why profitability has been associated with outperformance and whether it will continue to outperform in the future.

The critics also question the use of current profitability as a proxy for the future profitability stream. While they acknowledge that higher profitability today is correlated with higher profitability for the next few years (and is reflected in the current price), they do not allow the possibility that higher profitability will continue for some period in the future. DFA’s analysis showed that current profitability is significantly positively related to future profitability for seven years out. This meets our satisfaction, but perhaps not that of certain critics.

After reviewing these criticisms, we are still left with the data from around the world that shows a strong relationship between current profitability and subsequent returns. It may be like momentum, where it has been clearly observed but no widely accepted explanation has been proffered. Even the value premium has not been explained to everybody’s satisfaction. One school of thought offers a risk-based explanation while the other school relies on a behavioral explanation. IFA is in the risk-based school of thought.

One critic questioned an alleged discrepancy between the data presented earlier in this article (which showed about a 0.5% gain from a profitability tilt) and the data presented in an article published by DFA that showed a 5% gain. This is easily explained. The data presented in this article simply shows a simulated difference between existing funds and those funds with a direct profitability screen added to them. The DFA article presents the difference between two extreme indexes of high profitability vs. low (including negative) profitability.

IFA’s position is that since the data clearly, and with statistical significance, shows a direct relationship between profitability and expected returns, it is something that should be acknowledged, like momentum, even if we cannot fully explain it. We expect that at worst, profitability will be fully reflected in market prices (i.e., higher profitability companies will have the same expected returns as lower profitability companies), in which case, no harm done. At best, the return premium that occurred in the past will continue and our clients will benefit from having the increased exposure to direct profitability.

As an investment fiduciary, IFA will continue to watch developments related to the future incorporation of profitability in the funds that we advise for our clients. If you have any questions on profitability or any other investment-related topic, please feel free to drop us a line at [email protected].

1Direct profitability is calculated as operating income before depreciation and amortization minus interest expense divided by book value.

2Gerard O’Reilly, Savina Rizova, and Lukas Smart, “Applying Direct Profitability to Value Stocks,” Dimensional Fund Advisors’ Quarterly Institutional Review 9, no. 2 (2013b):1-14.