Admittedly, we evidence-based advisors can dive a little deeper into the investment weeds than most folks want to go. As an investor, you just want to know how to pursue the best after-cost returns for the investment risks you’re willing to take. We, on the other hand, love to explain how those costs, risks and returns really work. Indulge me as I describe in English (I promise) how the profitability factor matters to your end goal as an investor.
The roots of profitability investing
First, what is the profitability factor? As the name suggests, stock returns of profitable companies are expected to be higher than unprofitable ones. I’ll explain in a moment why that does not mean you should rush out and buy a bunch of high-flying stocks. Instead, we suggest combining this factor with others to strengthen your personal investment portfolio.
Investing a portion of your wealth in profitable companies makes intuitive sense. For example, a rental house with high rental income and low maintenance expenses will produce higher profits. Consistent higher profits into the future should create a larger return for the property owner.
It seems stocks should work that way too. A series of academic studies have demonstrated that current gross profitability has indeed been a good proxy for profits into the future. Most notably, a 2013 landmark study by Robert Novy-Marx built on earlier research by Eugene Fama and Kenneth French. Novy-Marx defined gross profitability as revenue minus the cost of operations. In other words, companies with higher cash flow after they sell a product or service also tended to have higher future stock returns.
Back to our rental house example: If the utilities, lawn care and property tax costs are low, the owner may expect higher profits now and in the future. If a company is more profitable than others today, it’s likely (although not guaranteed) to be more profitable than others in the future.
Diversifying for fun and profitability
This begs the question: Why not invest entirely in profitable companies? The answer is profitability is just one of several factors contributing to higher expected returns and not necessarily the most significant one. In fact, the profitability factor pairs well with another important factor: the value factor.
It is well documented that, over time, cheaper (value) stocks have outperformed pricier (growth) stocks. But not always. That’s where profitability comes in, with its low correlation to value. In other words, when the value factor underperforms, the profitability factor tends to outperform, and vice-versa. Holding both in your portfolio can help reduce risk and increase overall expected return. The chart below shows that value and highly profitable companies do not always have high or low performance at the same time and this decreases volatility.
Taking this a step further, a value investment strategy that excludes unprofitable companies’ stocks and holds more profitable ones can increase overall expected returns. To apply this to our rental house illustration, even if the resale value is not increasing, the high profits from the rental unit still provide a return on the investment.
One more point strengthens the appeal of the profitability factor: It has shown up around the world. Just as it shouldn’t matter whether our profitable rental home is in Grand Rapids or Tokyo, evidence has suggested profitable companies in the U.S. or abroad (including emerging markets) have delivered higher stock returns over the long term.
Having a geographically diverse portfolio is already an important way to reduce the concentrated risks of investing in any one region. We can enhance a globally diversified portfolio further by adding in profitability.
The end goal
As an investor, your end goal is to maximize expected returns while minimizing investment risks. It’s hard to reliably achieve this goal by randomly picking stocks or chasing market trends. Instead, we suggest harnessing decades of academic evidence on how to build a diversified portfolio, optimized to achieve your personal investment goals — including making good use of the profitability factor.
That’s a lesson you can take home with you.