Profitability

Profitability: An Added Dimension of Value Investing

Profitability

Profitability Painting

Research into common characteristics of stocks that've produced better results for investors keeps evolving. Along these lines, an important discovery in the field of financial economics is identification of the profitability premium.

In such a view, profitability is measured by the ratio of operating profitability minus interest expense to book value. In essence, this is a calculation to drill into a company's income statement, which shows differences between revenues, costs and expenses.

To investors, such a breakdown is crucial to understanding if a business is generating profits or running in the red. In assessing research spanning 50-plus years (1964-2016), Dimensional Fund Advisors (DFA) has reached a conclusion that not only does "current profitability hold information about future profitability," but "firms with higher profitability have had higher returns than those with low profitability."1 

Other highly cited academic work leading to similar insights includes research by professors Eugene Fama and Kenneth French2 as well as Robert Novy-Marx.3 

Indeed, this premium has proved to be a valuable analytical tool for us in designing globally diversified index-based portfolios. As a result, IFA has decided to offer a dedicated "high profitability" implementation. It's designed as an alternative for IFA clients whose investment plans might benefit from a larger tilt to such a premium. 

Of course, IFA Index Portfolios already incorporate such an added dimension of returns. This is largely accomplished through our preferred fund company, DFA, and its specialized stock screening process. Besides profitability factors, Dimensional targets stocks with characteristics related to size and value, which have also been identified by leading academic researchers as long-term drivers of higher equity returns.

Different tilts can deliver varying premiums over time. Dimensional's research, however, finds that emphasizing such market factors tends to increase a diversified global portfolio's chances of producing higher expected returns. For example, the graphic below shows that favoring more profitable stocks has led to a greater probability (89%) of outperforming a non-factor tilted MSCI all-world equity index after three years of implementation.   

What is particularly notable, however, is that combining size, value and profitability factors increased the probability of outperformance. This remained constant from the first year in which such a tilt is assumed through year three of implementation. 

Before deciding on a profitability implementation, an IFA wealth advisor can provide a high-level overview of what exposure to our profitability implementation means in a practical sense. 

As an example, let's consider an IFA high profitability asset-allocation strategy utilized in IRA accounts. For this implementation, IFA replaces the Schwab S&P 500 fund with the DFA US High Relative Profitability fund. (It's worth noting that IFA also offers a high profitability implementation for taxable accounts.) 

Both of these funds land in the U.S. large-cap blend category and don't diverge much in terms of market capitalization size, according to Morningstar data (through June 30). The rest are divvied up among mid caps. Neither provides exposure to small caps. 

Differences emerge between each fund's exposure to different major sectors of the U.S. market. (See table below.) Through the first-half of 2020, the S&P 500 fund put more stock in financials, real estate (DFA considers this a separate asset class), communication services and utilities. By comparison, the profitability fund overweighted some industries that can be considered as more growth-oriented in style: information technology (35.06% vs. 27.5%); health care (16.31% vs. 14.6%) and consumer discretionary, (15.69% vs. 10.8%).   

The DFA profitability fund, on the other hand, is more concentrated. This lends to the fact that while investing in some 253 different stocks, it had roughly half as many names as the Schwab S&P fund. Greater diversification, of course, tends to provide a smoother ride for investors through a lifetime of investing. 

With a more compact set of holdings, the profitability implementation comes as part of a globally diversified IFA Index Portfolio that provides coverage of more than 13,000 different companies across 40-plus countries.  

The end result is a portfolio alternative that leans a bit more to the profitability premium. This can provide an increased exposure to growth-styled stocks, particularly in the information technology area. On the whole, though, these profitability implementations don't increase an IFA Index Portfolio's outlook in terms of expected returns. 

As the scatterplot below illustrates, over the past 45-plus years traditional IFA portfolios compared to those tilting to profitability indexes produced similar risk and return profiles. In fact, these numbers wound up so close that you need to click on a portfolio's dot to get the results for both. (Click on the "Standard Implementation" button and the "High Profitability Implementation" to compare either option.) 

Since these alternative portfolios don't come along with profiles suggesting higher expected returns, a natural question is: "Why should an investor pick a profitability implementation as opposed to a regular IFA Index Portfolio?"

Professor Novy-Marx, who is perhaps the most highly cited academic researcher in this area, observes that "we really think about the profitability premium in very much the same way as we think about the value premium."4

Simply put, screening stocks by a company's level of profitability "helps you get a more informative price signal," he says. "And so, if you're looking at two firms that have similar relative prices … it makes relative price more informative."

In explaining the importance of implementing a company's profitability into the valuation mix, Novy-Marx likes to pass along a lesson from famed value investor Warren Buffett. That is: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." 

The profitability factor, suggests Novy-Marx, helps investors to identify "wonderful companies" selling at "fair" prices. "The wonderful companies are the ones that have high profitability," he says. "They on average have higher future expected cash flows and are going to return more capital to you." 

Footnotes:

  1. Dimensional Fund Advisors, "Evolution of Financial Research: The Profitability Premium," April 3, 2017. 
  2. Eugene Fama and Kenneth French, "Profitability, Investment, and Average Returns," Journal of Financial Economics, vol. 82 (2006), 491–518.
  3. Robert Novy-Marx, "The Other Side of Value: The Gross Profitability Premium," Journal of Financial Economics, vol. 108 (2013), 1–28.
  4. Robert Novy-Marx, Dimensional Fund Advisors investment seminar, June 16, 2020. 

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey (www.ifa.com/survey) to determine which portfolio captures the right mix of stock and bond funds best suited to you.  For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.