Accessing the Profitability Factor

A June 2012 study by Robert Novy-Marx, “The Other Side of Value: The Gross Profitability Premium,” provides investors with new insights into the cross section of stock returns. Among the important findings were:

• Profitability, as measured by gross profits-to-assets—gross profits being sales minus cost of goods sold—has roughly the same power as book-to-market (a value measure) in predicting the cross section of average returns.
• Surprisingly, profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios (higher price-to-book ratios).
• Profitable firms tend to be growth firms—that is, they grow faster. Gross profitability is a powerful predictor of future growth in gross profitability, earnings, free cash flow and payouts.
• The most-profitable firms earn 0.31 percent per month higher average returns than the least-profitable firms. The data is statistically significant (t-statistic of 2.49).
• Controlling for profitability dramatically increases the performance of value strategies, especially among the largest, most liquid stocks.
• Because strategies based on profitability are growth strategies, they provide an excellent hedge for value strategies—adding profitability on top of a value strategy reduces the strategy’s overall volatility.

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