The Evolution of Financial Research

The Profitability Premium and Financial Research

Since the 1950s, there have been numerous breakthroughs in the field of financial economics that have benefited both society and investors. One early example, resulting from research in the 1950s, is the insight that diversification can increase an investor’s wealth. Another example, resulting from research in the 1960s, is that market prices contain up–to-the-minute, relevant information about an investment’s expected return and risk. This means that market prices provide our best estimate of a security’s value. Seeking to outguess market prices and identify over- and undervalued securities is not a reliable way to improve returns.

This long history of innovation in research continues to the present day. As academics and market participants seek to better understand security markets, insights from their research can enable investors to better pursue their investment goals. In this article, we will focus on a series of recent breakthroughs into the relationship between a firm’s profitability and its stock returns. As we will see, an important insight Dimensional drew from this research is how profitability and market prices can be used to increase the expected returns of a stock portfolio without having to attempt to outguess market prices.

Differences In Expected Returns

The price of a stock depends on a number of variables. For example, one variable is what a company owns minus what it owes (also called book value of equity). Expected profits and the discount rate investors apply to these profits, are others. This discount rate is the expected return investors demand while holding the stock. The impact of financial market participants trading stocks is that market prices quickly find an equilibrium point where the expected return of a stock is commensurate with what investors demand. Decades of theoretical and empirical research have shown that not all stocks have the same expected return. Stated simply, investors demand higher returns to hold some stocks and lower returns to hold others. Given this information, is there a systematic way to identify those differences?

Market prices and expected future profits contain information about expected returns. While we can readily observe market prices as stocks are traded (think about a ticker tape scrolling across a television screen), we cannot observe market expectations for future profits or future profitability, which is profits divided by book value. So how can we use an unobserved variable to tell us about expected returns?

A paper by Professors Eugene Fama and Kenneth French published in 2006 tackles this problem. Fama and French have authored more than 160 papers. They both rank within the top 10 most-cited fellows of the American Finance Association and in 2013, Fama received a Nobel Prize in Economic Science for his work on securities markets. Fama and French explored which financial data that is observable today contains information about expected future profitability. They found that a firm’s current profitability contains information about its profitability many years hence. What insights did Dimensional glean from this? Current profitability contains information about aggregate investors’ expectations of future profitability.

Measuring Profitability

The next academic breakthrough in profitability research was done by Professor Robert Novy-Marx, a world-renowned expert on empirical asset pricing. Building on the work of Fama and French, he explored the relation of different measures of current profitability to stock returns. Profits equal revenues minus expenses. One particularly important insight Dimensional took from Novy–Marx’s work is that not all current revenues and expenses have financial information about future profits. For example, firms sometimes call a revenue or expense “extraordinary” when they do not expect it to recur in the future. If those revenues or expenses are not expected to recur, should investors expect them to contain information about future profitability? Probably not.

This is what Novy-Marx found when conducting his research. In a paper published in 2013, he used US data since the 1960s and a measure of current profitability that excluded some non-recurring costs so that it could be a better estimate for expected future profitability. In doing so, he was able to document a strong relationship between current profitability and future stock returns. That is, firms with higher profitability tended to have higher returns than those with low profitability. This is referred to as a profitability premium.

Around the same time, the Research team at Dimensional was also conducting research into profitability. They extended the work of Fama and French and found that in developed and emerging markets globally, current profitability has information about future profitability and that firms with higher profitability have had higher returns than those with low profitability. They also found that this observation held true when using different ways of measuring current profitability. These robustness checks are important to show that the profitability premiums observed in the original studies were not just due to chance. Their research indicated that when using current profitability to increase the expected returns of a real-world strategy, it is important to have a thoughtful measure of profitability that provides a complete picture of a firm’s expenses while excluding revenues and expenses that may be unusual and therefore not expected to persist in the future.

The Cutting Edge: New Research

Conclusion

In summary, there are differences in expected returns across stocks. Variables that tell us what an investor has to pay (market prices) and what they expect to receive (book equity and future profits) contain information about those expected returns. All else equal, the lower the price relative to book value and the higher the expected profitability, the higher the expected return. What Dimensional has learned from its own work and the work of Professors Fama, French, Novy-Marx, and Wahal, as well as others, is that current profitability has information about expected profitability. This information can be used in tandem with variables like market capitalization or price-to-book ratios to extract the differences in expected returns embedded in market prices. As such, it allows investors to increase the expected return potential of their portfolio without trying to outguess market prices.

GLOSSARY

Book Value of Equity: The value of stockholder’s equity as reported on a company’s balance sheet.

Discount Rate: Also known as the “required rate of return” this is the expected return investors demand while holding a stock.

Out-of-sample: A time period not included or directly examined in the data series used in statistical analysis.

Market Microstructure: The examination of how markets function in a fine level of detail, this can include areas of inquiry such as: how traders interact, how security orders are placed and cleared, and how information is relayed and priced.

Empirical Asset Pricing: A field of study that uses theory and data to understand how assets are priced.

Profitability Premium: The return difference between stocks of companies with high profitability over those with low profitability.

Realized Profitability Premium: The realized, or actual, return the difference in a given time period between stocks of companies with high profitability over those with low profitability.

INDEX DESCRIPTIONS

Dimensional US Low Profitability Index was created by Dimensional in January 2014 and represents an index consisting of US companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three low-profitability subgroups. It is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat.

Dimensional US High Profitability Index was created by Dimensional in January 2014 and represents an index consisting of US companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three high-profitability subgroups. It is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat.

Dimensional International Low Profitability Index was created by Dimensional in January 2013 and represents an index consisting of non-US developed companies. It is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization of each eligible country. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three low-profitability subgroups. The index is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: Bloomberg.

DIMENSIONAL INTERNATIONAL HIGH PROFITABILITY INDEX WAS CREATED BY DIMENSIONAL IN JANUARY 2013 AND REPRESENTS AN INDEX CONSISTING OF NON-US DEVELOPED COMPANIES. IT IS COMPILED BY DIMENSIONAL. DIMENSIONAL SORTS STOCKS INTO THREE PROFITABILITY GROUPS FROM HIGH TO LOW. EACH GROUP REPRESENTS ONE-THIRD OF THE MARKET CAPITALIZATION OF EACH ELIGIBLE COUNTRY. SIMILARLY, STOCKS ARE SORTED INTO THREE RELATIVE PRICE GROUPS. THE INTERSECTIONS OF THE THREE PROFITABILITY GROUPS AND THE THREE RELATIVE PRICE GROUPS YIELD NINE SUBGROUPS FORMED ON PROFITABILITY AND RELATIVE PRICE. THE INDEX REPRESENTS THE AVERAGE RETURN OF THE THREE HIGH-PROFITABILITY SUBGROUPS. THE INDEX IS REBALANCED TWICE PER YEAR. PROFITABILITY IS MEASURED AS OPERATING INCOME BEFORE DEPRECIATION AND AMORTIZATION MINUS INTEREST EXPENSE SCALED BY BOOK. SOURCE: BLOOMBERG.

Dimensional Emerging Markets Low Profitability Index was created by Dimensional in April 2013 and represents an index consisting of emerging markets companies and is compiled by Dimensional. Dimensional sorts stocks into three profitability groups from high to low. Each group represents one-third of the market capitalization of each eligible country. Similarly, stocks are sorted into three relative price groups. The intersections of the three profitability groups and the three relative price groups yield nine subgroups formed on profitability and relative price. The index represents the average return of the three low-profitability subgroups. The index is rebalanced twice per year. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: Bloomberg.

DIMENSIONAL EMERGING MARKETS HIGH PROFITABILITY INDEX WAS CREATED BY DIMENSIONAL IN APRIL 2013 AND REPRESENTS AN INDEX CONSISTING OF EMERGING MARKETS COMPANIES AND IS COMPILED BY DIMENSIONAL. DIMENSIONAL SORTS STOCKS INTO THREE PROFITABILITY GROUPS FROM HIGH TO LOW. EACH GROUP REPRESENTS ONE-THIRD OF THE MARKET CAPITALIZATION OF EACH ELIGIBLE COUNTRY. SIMILARLY, STOCKS ARE SORTED INTO THREE RELATIVE PRICE GROUPS. THE INTERSECTIONS OF THE THREE PROFITABILITY GROUPS AND THE THREE RELATIVE PRICE GROUPS YIELD NINE SUBGROUPS FORMED ON PROFITABILITY AND RELATIVE PRICE. THE INDEX REPRESENTS THE AVERAGE RETURN OF THE THREE HIGH-PROFITABILITY SUBGROUPS. THE INDEX IS REBALANCED TWICE PER YEAR. PROFITABILITY IS MEASURED AS OPERATING INCOME BEFORE DEPRECIATION AND AMORTIZATION MINUS INTEREST EXPENSE SCALED BY BOOK. SOURCE: BLOOMBERG.

SOURCE: DIMENSIONAL FUND ADVISORS LP.

THERE IS NO GUARANTEE INVESTMENT STRATEGIES WILL BE SUCCESSFUL. DIVERSIFICATION DOES NOT ELIMINATE THE RISK OF MARKET LOSS.

ALL EXPRESSIONS OF OPINION ARE SUBJECT TO CHANGE. THIS ARTICLE IS DISTRIBUTED FOR INFORMATIONAL PURPOSES, AND IT IS NOT TO BE CONSTRUED AS AN OFFER, SOLICITATION, RECOMMENDATION, OR ENDORSEMENT OF ANY PARTICULAR SECURITY, PRODUCTS, OR SERVICES.

EUGENE FAMA IS A MEMBER OF THE BOARD OF DIRECTORS FOR AND PROVIDES CONSULTING SERVICES TO DIMENSIONAL FUND ADVISORS LP. HE IS A PROFESSOR OF FINANCE AT THE UNIVERSITY OF CHICAGO, BOOTH SCHOOL OF BUSINESS. IN 2013, HE RECEIVED A NOBEL PRIZE FOR HIS WORK ON SECURITIES MARKETS.

KEN FRENCH IS A MEMBER OF THE BOARD OF DIRECTORS FOR AND PROVIDES CONSULTING SERVICES TO DIMENSIONAL FUND ADVISORS LP. HE IS A PROFESSOR OF FINANCE AT THE TUCK SCHOOL OF BUSINESS AT DARTMOUTH COLLEGE.

ROBERT NOVY-MARX PROVIDES CONSULTING SERVICES TO DIMENSIONAL FUND ADVISORS LP. HE IS A PROFESSOR OF FINANCE AT THE UNIVERSITY OF ROCHESTER, SIMON BUSINESS SCHOOL.

SUNIL WAHAL PROVIDES CONSULTING SERVICES TO DIMENSIONAL FUND ADVISORS LP. HE IS A PROFESSOR OF FINANCE AT ARIZONA STATE UNIVERSITY, CAREY SCHOOL OF BUSINESS.