Myth-Busting: The Profitability Factor Is Profitable

What makes ROE so unique?

December 2025. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Selecting U.S. stocks on profitability metrics failed to generate excess returns
  • Only return-on-equity produced outperformance, but not when equal-weighting stocks
  • Difficult to explain why ROE worked, although it does not seem random

INTRODUCTION

In our recent article Quality versus Growth (read Quality vs Growth Factors), we showed that most portfolios constructed on traditional quality and growth metrics failed to deliver positive excess returns over the past 20 years. This is unsurprising: investors cannot consistently earn more than the market simply by holding stocks with appealing fundamentals – everyone loves these companies!

One notable exception was return-on-equity (ROE), which consistently generated attractive excess returns. Why does selecting companies based on ROE outperform metrics like operating margin, sales growth, low leverage, or low volatility? Is there anything unique about this metric?

In this research article, we examine various measures of profitability to answer this question.

LONG-TERM PERFORMANCE OF THE PROFITABILITY FACTOR

The profitability factor, or Robust minus Weak (RMW) in academic literature, is a key component of the Fama-French five-factor model. Plotting the long-short factor in the U.S. stock market over the past 60 years shows virtually zero excess returns from 1963 to 1983, followed by relatively consistent performance. The largest drawdown occurred during the 2000 tech bubble, when investors favored unprofitable technology firms.

Most investors, however, do not implement long-short portfolios and instead focus on top-ranked stocks. Looking at the top 10% and 30% most profitable U.S. stocks, excess returns relative to the market are positive, though smaller: the long-short factor achieved a CAGR of 3.2% from 1963 – 2025, compared with 1.0% for the top 10% and 1.1% for the top 30%.