The Investment Scientist

Archive for June 2018

In my last newsletter I discussed the profitability premium.  It, along with the small cap premium and value premium, form the three established directions whereby investors can improve their expected returns on their stock investments.

To be more specific, to improve expected returns, an investor should tilt their portfolio towards profitable companies, small cap stocks and value stocks.

However, one must keep in mind that return premiums are not certainties. There will be periods, sometimes rather extended periods,  during which:

  • Small cap stocks underperform large cap stocks
  • Value stock underperform growth stocks and
  • Profitable stocks underperform unprofitable stocks

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Ever since Fama and French published their seminal paper “The Cross-Section of Expected Stock Returns” in 1992, the world (at least the academic world) has come to understand that over the long run, small cap stocks outperform large cap stocks and value stocks outperform growth stocks.

This quest to understand stock returns has not stopped. In 2013, Robert Novy-Marx published “The Other Side of Value: The Gross Profitability Premium” in the Journal of Financial Economics. In the course of this research, he discovered that profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market in predicting the cross-section of average returns. Profitable firms generate significantly higher returns than unprofitable firms, despite having higher valuation ratios.

Almost concurrently, other researchers confirmed Novy-Marx’ discovery, notably Fama and French’s new paper “A Five Factor Asset Pricing Model” and Hou, Xue and Zhang’s “Digesting Anomalies: An Investment Approach.” Both papers were published in 2015.

Unlike the small cap premium and value premium, the profitability premium does not have a satisfactory risk-based explanation.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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