When constructing or evaluating a domestic stock fund portfolio, Index Fund Advisors has traditionally utilized the three-factor asset pricing model that professors Eugene Fama and Ken French introduced in the early 1990s.¹ 

This model states that the expected return of a broadly diversified stock portfolio — in excess of a risk-free rate — is a function of that portfolio's sensitivity or exposure to three common risk factors:

• A market risk factor, as measured by the excess return of a broad equity market portfolio relative to a risk-free rate.
• A size factor, as measured by the difference between the returns of a portfolio of small stocks and the returns of a portfolio of large stocks.
• A value factor, as measured by the difference between the returns of a portfolio of high book-to-market (value) stocks and the returns of a portfolio of low book-to-market (growth) stocks.

The underlying premise of the Fama/French Three-Factor Model is that small-cap and value stocks carry higher expected returns compared to large-cap and growth stocks.

Besides these three factors, market researchers have also identified a so-called profitability premium. Simply put, this means that tilting to stocks of firms with relatively higher profit levels is a reliable way to increase a stock portfolio's expected returns. Likewise, using mutual funds and exchange-traded funds that tilt allocations to such a known premium helps us to improve an IFA Index Portfolio's expected return in a highly quantifiable and systematic manner. 

Tracking the Profitability Premium

Discovery of such an investment premium has taken time, however. The hunt to identify and accurately track profitability as a factor of a portfolio's expected return, in fact, has taken decades of testing and statistical analysis. 

Although many academics over the years explored such a topic, a paper by Fama and French that was published in 2006 stands out to us as setting the stage for establishment of the profitability premium. In this piece, the authors took a deep dive into what information could be gleaned from stock prices and investors' expectations about a firm's future profits.²

What they found was that a firm's current profitability contains information about its expected profitability over longer periods. As a result, building on their earlier three-factor model, Fama and French formally expanded that model by introducing the profitability factor. 

How powerful was this finding? Below, we've developed tables based on research by Dimensional Fund Advisors. The fund company crunched data over statistically significant periods for all four factors — market risk, value, size and profitability. It shows how exposing a portfolio to these factors raises the odds of increasing expected returns during overlapping rolling periods.

This graphic not only compiles results for U.S. exposure to these factors over extended periods, it also provides buttons to compare probabilities of increased returns in developed international and emerging markets stocks. Notice how exposure to such factors over longer rolling periods only served to improve chances that investors would capture higher returns.

Research by Novy-Marx

The findings of Fama and French led to further research into this factor by Robert Novy-Marx, a highly cited academic researcher of empirical asset pricing. 

In a paper published in 2013, he concluded that profitability is a strong predictor of a company's future growth as well as of earnings and free cash flow. Of particular interest, Novy-Marx found that adding a profitability factor worked especially well when combined with the value factor. ³

We should also point out such an analysis calculated profitability in terms of operating income (before depreciation and amortization) and minus interest expense divided by book equity. The graphic below is designed to bring greater clarity to how meaningful such a profitability premium has proved to be for globally diversified index fund investors over the longer haul. 

Refinements in Profitability Research

Another significant advance into work on the profitability premium came a few years later. A research paper that was last revised in 2018 by Sunil Wahal, an Arizona State University professor, provides investors with what's known as "out-of-sample" evidence of the profitability premium.⁴ This is important since such out-of-sample research can serve as additional confirmation of results garnered from in-sample testing of data. 

Even using a different type of testing regime, Wahal found much the same. It's also worth noting that his research distinguished itself by analyzing earlier periods. Previous work by Fama, French and Novy-Marx used U.S. data beginning in 1963. The reason: When they did their research, computer-generated information relating to corporate financial statements and stock profitability weren't readily available to researchers until the early 1960s. 

As DFA researchers put in a 2017 paper reviewing scientific advances in the search to quantify the profitability premium:⁵

Wahal rose to those challenges. He gathered a team of research assistants to hand-collect accounting statement data from Moody's Manuals from 1940 to 1963. By applying his (and his team's) expertise in accounting, combined with a great deal of meticulous data checking, Wahal was able to produce reliable profitability data for all US stocks from 1940 to 1963. Using this data to measure the return differences between stocks with high vs. low profitability, Wahal found similar differences in returns to what had been found in the post-1963 period.

The review added: "This research provides compelling evidence of the profitability premium pre-1963 and is a powerful out-of-sample test that strengthens the results found in earlier work."

Taking a Longer-Term Perspective

While the four-factor model can be considered an improvement over the three-factor model, a potential downside for some wealth managers might be the added complexity of another dimension in determining a portfolio's expected returns. With the three-factor model, we can easily visualize the expected return of a portfolio relative to the market based on where it plots on a two-dimensional chart of size and value exposure. With profitability added, we need a three-dimensional chart.

This should not be a cause for despair. Since returns are so noisy to begin with, we can't expect to refine the science of portfolio construction without some necessary enhancements. We've learned over the years from a wealth of comprehensive research by leading academics — as well as performance reviews of thousands of client portfolios — that extending the Fama/French Three-Factor Model has served as an important evolution in our empirical work with IFA Index Portfolios.

As an independent wealth management fiduciary, IFA will continue to keep abreast of developments in finance to ensure that our clients have the best possible investment experience that we can provide. If you have any questions on profitability, multi-factor models of portfolio returns — or any other wealth management topic — please feel free to contact one of our wealth advisors.

Footnotes:

1.) Eugene Fama and Kenneth French, "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, 1993.

2.) Eugene Fama and Kenneth French, "Profitability, Investment and Average Returns," Journal of Financial Economics, 2006. 

3.) Robert Novy-Marx, "The Other Side of Value: The Gross Profitability Premium," Journal of Financial Economics, 2013.

4.) Sunil Wahal, "The Profitability and Investment Premium: Pre-1963 Evidence," Journal of Financial Economics, 2018 (last revised.)

5.) Dimensional Fund Advisors, "Evolution of Financial Research: The Profitability Premium," 2017. 

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