Picking Highly Profitable Businesses Can Be Unprofitable

Evaluating the Unusual Characteristics of the Profitability Factor

August 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • There seems to be a relationship between the Profitability factor and interest rates
  • The most profitable stocks outperformed the least profitable ones when market cap-weighted
  • However, when equal-weighted, the least profitable stocks outperformed

INTRODUCTION

The gap between theory and reality in finance is sometimes fuzzy, at other times crystal clear. Ask an academic what explains stock returns and he will come up with three to six factors, which are supported by hundreds of research papers from across the globe. Ask an ETF analyst to show you the money and he might point out that investors have allocated $265 billion to smart beta ETFs in the US that focus on Growth stocks, which represents a factor that has very little academic support, compared to only $195 billion in Value. It seems that the majority of these ETF investors do not only ignore research that literally spans centuries, but are perfectly happy to take the other side of the trade. Stated differently, they are shorting science and armies of PhDs.  

However, other academically-established factors do much worse than Value. For example, it is challenging to find any ETF that offers exposure to the Investment factor, which is part of Fama-French’s five-factor model. Perhaps this one is simply too esoteric for most folks as the portfolio is long stocks that exhibit slow asset growth and short ones that have high asset growth. What does that actually mean? And why should asset growth be relevant for stock returns?

Having said this, even more unusual is why there are only $20 billion in Quality-focused ETFs. Selecting stocks on measures like profitability is supported by research and equally emotionally appealing. Who does not like stocks that have high profit margins, feature low leverage, show consistent growth in sales and earnings, or have other attributes that demonstrate quality characteristics in businesses?

In this short research note, we will explore the Profitability factor and try to identify reasons that might explain the lack of popularity (read The Odd Factors: Profitability & Investment).

PERFORMANCE