The Odd Factors: Profitability & Investment

Odd, but attractive?

November 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The Profitability factor generated attractive returns in the US and Europe since 1990
  • It is difficult to explain why investors should be compensated for holding highly profitable companies
  • The Investment factor was less attractive and is unusual from a financial analyst’s perspective

INTRODUCTION

Discretionary and systematic investors tend to have different perspectives on what works in the stock market. On the topic of factor investing, both types of investors tend to agree that Value is an attractive strategy. It is intuitively appealing to discretionary investors given that everyone likes bargains while systematic traders can rely on a significant amount of academic research. Views diverge on the Momentum factor, which is too simple for most discretionary investors while being a favorite amongst systematic investors. Finally, there the Profitability and Investment factors from 5-factor model of Fama-French and the Q-factor model from Zhang, which are challenging for both types of investors. In this short research note, we will analyze these two factors – Profitability and Investment – across markets.

METHODOLOGY

We focus on the Profitability and Investment factors in the US, European and Japanese stock markets. Profitability is defined as return-on-equity and investment as the one-year change in total assets. Factor performance is calculated by creating long-short beta-neutral portfolios comprised of the top and bottom 10% of the stocks ranked by the factor. Only stocks with a market capitalization of larger than $1 billion are included. Portfolios are rebalanced monthly and each transaction incurs costs of 10 basis points.

THE PROFITABILITY FACTOR ACROSS MARKETS

Profitability is a subset of the Quality factor and may be attractive in times of market stress as these stocks should outperform weaker ones. However, it is questionable if the Profitability factor should generate positive returns across time. It is challenging to derive a theory of why investors should be compensated for holding highly profitable companies (read Quality Factor: Zero Alpha for Most Investors?).

However, in contrast to our expe