Decades of academic research have identified that there are systematic differences in expected returns based on what is commonly referred to as factors. We can exploit these factors to structure portfolios to target higher expected returns. An example is the profitability premium.
Persistent and Pervasive Factors
While there is no guarantee that these factors will continue to out-perform over time, empirical evidence has suggested that these factors have been persistent (i.e., occurred over time) and pervasive (i.e., occurred over the equity markets in various geographical regions).
4 “Premiums” of Return
Over the next several weeks, we are discussing the four factors that have been shown to be persistent and pervasive. These factors give rise to “premiums” of return. These premiums are:
- Equity premium
- Small cap premium
- Value premium
- Profitability premium
To be considered a dimension of expected return, a premium must be all of the following:
This week: The Profitability Premium
This week we are going to take on the profitability premium. The profitability premium is based on empirical evidence (i.e., data) that suggests that companies with higher profitability will outperform companies with a larger profitability.
The profitability premium – as plain as the nose on your face!
Of all of the premiums, this is the one that is far and away the easiest to explain AND the one that yields the most “DUH!” responses. Alabama has an old song that says “if you’re going to play in Texas, you better have a fiddle in the band.” The investing equivalent might be well stated as:
- If you’re going to invest in the market, you better do so in profitable companies.
Business is about making money. If you don’t make money, you go out of business. If you go out of business, you are no longer listed on the stock exchange and your stock value goes to zero.
The profitability premium suggests that you are better off leaning into companies that make more money (are more profitable). This statement is very obvious, and that is why many respond with “DUH” when they hear about the profitability premium.
What is the key to the Profitability Premium?
While obvious, it has not always been fully leveraged. Furthermore, one of the keys in implementing the profitability premium is to focus on the TRACK RECORD of companies in regards to profitability versus the “promise” of profitability, or—in the illustrious words of Jerry McGuire—“Show Me The Money!”
Hopefully pulling in references to Alabama and Jerry McGuire will help you to remember this final premium and inspire you to investigate the concept of factor-based investing a bit further.
The profitability premium – both persistent and pervasive
The profitability premium has been shown to be persistent and pervasive. For that reason, a portfolio that “over weights” or “leans” into profitable companies has been shown to have a higher expected return over the long run.
That’s all folks
Over the past two months, we have highlighted the four premiums that are at the core of factor-based investing. Hopefully this series has provided you with some insights into investing AND caused you to challenge your basic beliefs about what “investing” is versus what “speculating” is.
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