Robert Novy-Marx’s 2013 paper “ The Other Side of Value: The Gross Profitability Premium” not only provided investors with new insights into the cross-section of stock returns but also helped further explain some of Warren Buffett’s superior performance. Novy-Marx built upon a 2006 paper, “Profitability, Investment, and Average Returns,” by Eugene Fama and Kenneth French, who showed that firms with high profitability measured by earnings have high subsequent returns after controlling for book-to-market ratio and investment. As is the case with other factors, profitability had been used for decades by practitioners such as Benjamin Graham and David Dodd. Novy-Marx’s work investigated gross profits, defined as sales minus the cost of goods sold, over the period 1962 through 2010.
Following is a summary of his findings:
- Profitability, as measured by the ratio of gross profits to assets, has roughly the same power as the book-to-market ratio (a value measure) in predicting the cross-section of average returns.
- Surprisingly, profitable firms generated significantly higher returns than unprofitable firms despite having significantly higher valuation ratios (for instance, higher price-to-book ratios).
- Profitable firms tend to be growth firms, meaning they expand comparatively quickly. Gross profitability is a powerful predictor of future growth as well as of earnings, free cash flow, and payouts.
- The most profitable firms earned returns 0.31 percent per month higher on average than the least profitable firms (t-stat = 2.49).
- The abnormal return (alpha) of the profitable-minus-unprofitable return spread relative to the Fama-French three-factor model was 0.52 percent per month (t-stat = 4.49).
- The returns data were economically significant, even among the largest, most liquid stocks.
- Gross profitability has more power in predicting the cross-section of returns than earnings-based measures of profitability.
- Controlling for profitability dramatically raises the performance of value strategies, especially among the largest, most liquid stocks. Controlling for book-to-market ratio improves the performance of profitability strategies. Controlling for profitability provides less help for other value strategies because, while book-to-market is negatively correlated with profitability, other value metrics (such as price-to-cash-flow and enterprise-value-to-EBITDA, or earnings before taxes, interest, depreciation, and amortization) are positively correlated with profitability.
- While the more profitable growth firms tend to be larger than less profitable growth firms, the more profitable value firms tend to be smaller than less profitable value firms.
- Strategies based on gross profitability generate value-like average excess returns even though they are actually growth strategies.
- Because both gross-profit-to-assets and book-to-market ratios are highly persistent, the turnover of both the profitability and value strategies is relatively low.
- Strategies built on profitability are growth strategies, so they provide an excellent hedge for value strategies. Adding profitability on top of a value strategy reduces the strategy’s overall volatility.
Building on Novy-Marx’s work, in their 2020 study “ On the Conjoint Nature of Value and Profitability,” Sunil Wahal and Eduardo Repetto showed that combining the two strategies, tilting exposure to the two factors, in long-only portfolios improved the performance of value strategies.
Latest Research on the Profitability Factor
Bradley Blaylock, Bradley Lawson, and Michael Mayberry contribute to the profitability literature with their study “ Taxable Income, Future Profitability, and Stock Returns,” which was published in the July-August 2020 issue of the Journal of Business, Finance, and Accounting. They examined how taxable income relates to future performance. They measured performance along three different dimensions: (1) future pretax cash flows, (2) future pretax book income, and (3) future ‘Street’ pretax earnings. Their data sample covered the period 2002 to 2016. They regressed one, two, and three-year-ahead future performance measures on taxable income and controlled for either pretax book income or its components (i.e., cash flows and accruals).
Following is a summary of their findings:
- Taxable income was positively associated with future pretax cash flows, pretax book income, and Street pretax earnings over a three-year horizon. It ceased to be a reliable signal of future performance by year t+4.
- A one standard deviation increase in taxable income predicted a 9.2% to 24.7% increase in future performance for year t+1.
- There was a significantly positive association between taxable income and analysts’ future pretax forecasts across all time horizons—taxable income not only predicts future pretax performance but also influences analysts’ expectations of future performance.
- There is no significant association between taxable income and future forecast errors—analysts efficiently utilize taxable income as a useful signal of multiple performance measures and employ these signals in their forecasting process.
Their findings led Blaylock, Lawson and Mayberry to conclude:
Overall, our results are consistent with taxable income being a signal of firms’ fundamental values. That is, higher taxable income predicts stronger future performance.
We find a significantly positive association between taxable income and analysts’ future pretax forecasts, consistent with taxable income influencing future earnings expectations.
The research demonstrates that profitability provides incremental explanatory power to the cross-section of returns while also providing a premium that has been persistent, pervasive around the globe, robust to various definitions, and implementable (low turnover). In addition, adding exposure to the profitability factor provides a portfolio diversification benefit, as it has exhibited low to negative correlation to the market beta, size, value, and momentum factors. Such benefits are why fund families such as AQR, Alpha Architect, Avantis, BlackRock, Bridgeway, and Dimensional incorporate the strategy into portfolio construction design. 1
- (Full disclosure: My firm recommends funds from the AQR, Avantis, BlackRock, Bridgeway, and Dimensional fund families in client portfolios.) ↩