Two Sides of the Coin
Profitability and value are two sides of the same coin and ought to be considered as complementary peers or jointly in a combined strategy.
By: Brian Chingono and Annie Colloredo-Mansfeld
“A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.” — Benjamin Graham, The Intelligent Investor
When Ben Graham first published these words in 1949, he succinctly summarized a theory that academics would spend the next 70 years formalizing with equations, reams of financial data, and ever-more-powerful computers. Graham’s colloquial summary was prescient on at least two levels.
First, he correctly pointed out that stock prices can move independently of a company’s “intrinsic value,” as represented by the sum of its future profits. Just because a company’s stock price drops today doesn’t necessarily mean that there is a permanent impairment to its aggregate future profits. Similarly, just because a stock price has rallied today, doesn’t necessarily mean that the business has permanently increased its future profits.
Second, Graham’s summary was wise because it implied that price and future profitability are relevant metrics for investors to consider, even though they can move independently of each other. So to make good investment decisions, investors need to both consider the price at which a business is trading today and also find a good proxy for the company’s future profits.
The importance of this consideration is summarized in the relationship below, which demonstrates that investor returns are increased by either purchasing an average stream of profits at lower prices or by purchasing a higher stream of future profits at average prices.
The key challenge is to get an edge on predicting future profits—a task, as we have written, that is far more challenging than most fundamental investors believe.
But while we believe it’s nearly impossible to predict the revenue or earnings growth of individual companies, we do think quantitative metrics can help predict which categories of companies are more likely to have stable or increasing earnings and which categories of firms have more fragile and risky earnings streams.
Perhaps the most important literature on this topic came in 2012, over 60 years after Ben Graham first wrote The Intelligent Investor, when Robert Novy-Marx published a paper on gross profitability (defined as Gross Profit/Assets). Novy-Marx found that Gross Profit/Assets is predictive of future profits and can thus identify higher quality companies with more robust future earnings streams. A more recent study by Sunil Wahal (2018) found that gross profitability today predicts gross profitability at least three years from now. Therefore, today’s gross profitability is a good proxy for a company’s future profitability—and a good proxy for quality, a topic we have been studying with great interest.
Investors can target gross profitability either on its own or in combination with a value strategy. A few weeks ago, we wrote about how a portfolio of high-quality stocks with high gross profitability can complement a value strategy, with the profitability portfolio often doing well when the value portfolio was underperforming and vice versa. We believe this approach can be particularly useful for countercyclical strategies, whereby the profitability sleeve can provide funding to double down on value during market crises. Value and profitability strategies can be held side-by-side in a portfolio because, as Novy-Marx points out, “despite generating significant returns on its own, [profitability] actually provides insurance for value.”
But gross profitability and value can also be merged in a single strategy. Quantitative investors can target the value and profitability factors jointly in a buy-and-hold strategy. Importantly, this second approach results in a different set of portfolio holdings because it would exclude or underweight some securities that don’t meet the joint criteria of high profitability and cheap valuation. Our friends at Avantis Investors have written two fantastic papers on targeting profitability and value jointly in the US and internationally, and we summarize their main concept in the figure below.
The bell curve on the left represents the stock market sorted by profitability (e.g., Gross Profit/Assets). In this curve, higher values are more attractive because they predict higher future profitability. And the bell curve on the right represents the stock market sorted by valuation (e.g., EV/EBITDA), whereby lower values are more attractive because they reflect cheaper prices. The intersection of the two curves—shown by the solid triangle—is where the analysis is most interesting. In a strategy that jointly targets profitability and value, the red “tails” of the triangle would either be excluded or underweighted. Therefore, a joint strategy would primarily target the cheap and profitable companies in the center of the triangle, minimizing exposure to the junkiest cheap stocks and the most expensive profitable stocks.
Figure 1: Joint Distribution of Profitability and Value
Source: Verdad research
We tested this joint combination of value and profitability using our preferred value metric (EV/EBITDA) and a measure of gross profitability that also accounts for free cash flow. Building on the insights of Chicago professor Ray Ball (2015) and his colleagues, we call this measure cash profitability, and it simply combines Gross Profit/Assets and Free Cash Flow/Assets into a single profitability metric.
The results of our analysis are summarized below, where we took all US and European stocks above $100M of market cap and independently sorted them into five groups (quintiles) by valuation and five groups by cash profitability to form 25 separate portfolios. This simple 5x5 sort yields remarkably consistent results across geographies, as shown in the return matrices below.
Figure 2: Annualized Returns (Dec 1997 – June 2021)
Sources: Capital IQ and Verdad research
In both of the above geographies, returns are maximized in the southeast corner of the matrix, where companies are simultaneously cheaper and more profitable. Companies that are in the cheapest and most profitable quintile have returned between 15% and 17% annualized over the period between 1997 and 2021. And looking at the diagonals of the return matrices, we can clearly see a monotonic increase in returns as we move from the least attractive portfolio (expensive and low profitability) to the most attractive portfolio (cheap and high profitability). Moreover, the return premium between the extremes of this diagonal is very robust at 21 percentage points per year in the US and 18 percentage points per year in Europe.
One might expect this return premium to come at the expense of higher risk. We were intrigued and somewhat surprised to find that this doesn’t seem to be the case. Drawdowns were generally lower in the cheap and highly profitable portfolios, as shown in the figure below.
Figure 3: Max Drawdowns (Dec 1997 – June 2021)
Source: Capital IQ and Verdad research
It was also interesting to see that average drawdowns across the highest profitability row were lower than average drawdowns along the cheapest column in both geographies, consistent with the logic of a side-by-side countercyclical approach.
The risk-return profile of a joint approach to profitability and value is summarized in the figure below, which shows the Sharpe ratio of each portfolio. In dividing the annualized return of each portfolio by its volatility, the Sharpe ratio aims to offer a simple measure of risk-adjusted returns. In both the US and Europe, companies that are both cheap and profitable seem to offer the best return per unit of risk.
Figure 4: Sharpe Ratios (Dec 1997 – June 2021)
Source: Capital IQ and Verdad research
As further evidence, the above results are consistent with the findings of Wahal and Repetto (2020), who create similar matrices among international developed markets and emerging markets. They also separate their analysis among small caps and large caps, and they find similar results (albeit with bigger return spreads among small caps). Importantly, Wahal and Repetto use different measures of value and profitability, yet their results are strikingly similar. We believe this is evidence of a robust scientific finding because it means that the relationship between profitability and value is not sensitive to measurement issues. The short paper by Wahal and Repetto (2020) is well worth a read as it provides compelling out-of-sample evidence relative to previous studies that have historically focused on the US.
As research on profitability progresses, there may be further room for improvement as researchers consider whether other earnings metrics can offer more precise forecasts of future profitability, and whether accounting for momentum can offer return enhancements as well. Kyosev et al. (2020) at Robeco have looked into these questions, and their findings suggest that there is potential for developing better predictors of future profitability.
Although the relationship between future profitability and today’s price has been studied for at least 70 years, we’re delighted to see that there is still room for researchers to remain curious and turn over more rocks in their endeavor to progress our collective knowledge even further.
Acknowledgement: This article was written with contributions from Annie Colloredo-Mansfeld, who is a junior at Harvard College. Annie is studying Government and Spanish, and she is a member of the Harvard women’s varsity polo team. After graduation, Annie is interested in a career in investing, as she works toward her dream of retiring as a rancher in Texas. We very much enjoyed working with Annie over the summer. Please let us know if you would like to connect with Annie, as we would be happy to put you in touch with her.