By Alex Bryan
It's surprising that value stocks have done as well as they have. Value stocks tend to be less profitable than their growth counterparts, and yet they have historically traded at steep enough discounts to outperform growth stocks in nearly every market studied over long horizons. But price is only one aspect of value. Controlling for risk, a company's future profitability drives its intrinsic value. While companies that consistently generate high profits command higher valuations than traditional value stocks, the market has also historically undervalued these companies. This anomaly is consistent with Warren Buffett and Charlie Munger's philosophy that it is better to buy a great company at a fair price than a fair company at a great price.
Profitability measures how productively a company uses its investors' capital and assets. Simply comparing net income or earnings per share across companies does not adequately capture this idea. It is often possible for a company to boost its net income by acquiring more assets, but that does not necessary improve its productivity--just the opposite. The marginal returns to capital tend to diminish with size. In other words, investors often get less "bang for the buck" for each additional dollar invested in the business. In order to control for differences in invested capital and assets, researchers define profitability using metrics, such as return on invested capital, gross profits/assets, and adjusted operating income/book value of equity.
While equity analysts spend a lot of time projecting future cash flows and profits, several recent studies have found that one of the best estimates of a firm's future profitability is its current profitability. Profitability tends to persist. For instance, Dimensional Fund Advisors found that profitability in one year could explain profits up to seven years in the future, using U.S. stock data from 1975-2012 (Dimensional Quarterly Institutional Review, first quarter 2013). This may be because the most profitable companies tend to be those with sustainable competitive advantages. The following table illustrates the average return on invested capital from 2010-12 for all U.S. stocks Morningstar covers with a market cap of at least $1 billion, grouped by economic moat rating. This rating reflects Morningstar's assessment of the durability of company's competitive advantage. Over this period, companies with the strongest competitive advantages (wide economic moats) generated the highest returns on invested capital.
Directionally, the market prices this information correctly. Highly profitable firms tend to command higher valuations than their less profitable counterparts. However, controlling for value, they have also historically offered better returns, which suggests that investors have not fully appreciated the persistence of profitability. Defining profitability as adjusted operating income/book value of equity, DFA found that the stocks of highly profitable firms in the U.S. outperformed the least profitable firms by more than 5% annualized from 1975-2012, with lower volatility. It also uncovered this relationship in foreign developed markets (1991-2012) and emerging markets (1995-2012), where the profitability performance gap was about 5% and 6%, respectively. Robert Novy-Marx published similar results in his paper, "The Other Side of Value: The Gross Profitability Premium," which defined profitability as gross profits/assets. He found that the most profitable U.S. firms outperformed their counterparts on the other side of the spectrum by about 3.8% annually, from 1963-2010.
Value and Profitability
While the profitability premium appears to be robust when controlling for value, the evidence is mixed when this control is removed. In a paper published in 2007, “The Profitability Premium in Equity Returns,” David Brown and Bradford Rowe found that the profitability premium went away without this control. This is because an unconstrained portfolio that targets profitable firms overweights growth stocks, which have historically underperformed value. However, they illustrated that the profitability premium is present across the value-growth spectrum. Consequently, both value and growth managers could improve their performance by tilting toward profitable firms. Similarly, Novy-Marx found that the benefit from targeting profitable firms becomes stronger when combined with value.
Efficient-market advocates have long argued that the value premium is compensation for risk. It is difficult to articulate a risk based explanation for the profitability premium that is consistent with this view. Where value stocks often represent distressed companies with dim growth prospects and poor recent performance, highly profitable firms tend to be high quality with durable competitive advantages. According to DFA's analysis, these stocks have also historically been less volatile. Does risk really increase with profitability? Not likely.
Yet, it is also difficult to identify a consistent behavioral explanation for both the value and profitability premiums. According to this school of thought, value stocks outperform because investors tend to extrapolate past growth too far into the future, pushing prices away from their fair values. But then why wouldn't investors make the same mistake with profitability? One possible explanation is that profitability doesn't inspire as much excitement as growth. Profitable companies, such as Johnson & Johnson (NYSE:JNJ), McDonald's (NYSE:MCD), and Microsoft (NASDAQ:MSFT), tend to be boring, mature, and high quality. It is easier to get excited about companies, such as Salesforce.com (NYSE:CRM) and Netflix (NASDAQ:NFLX), that offer disruptive technology and the possibility of large payoffs.
Investors may also mistakenly believe that growth will translate into profitability. However, if that growth requires substantial investments financed with new debt or equity, it could actually hurt profitability as diminishing marginal returns start to set in. Additionally, it is easier to sustain profitability than growth. A company can grow faster than its industry only by taking market share away from competitors or expanding into new industries. But as a company increases its market share, it becomes more difficult to maintain its rate of growth. And jumping into new industries, where synergies are questionable at best, is an easy way to destroy shareholder wealth (look up the conglomerate discount). In contrast, a company with a durable competitive advantage can sustain high profits for many years. For example, Coca-Cola's (NYSE:KO) extensive distribution network and iconic brand has enabled it to generate large profits peddling sugar water for decades. While Coke's days of explosive growth are behind it, these competitive advantages have endured.
Will It Last?
While the market has historically undervalued highly profitable firms, that may start to change as more investors become aware of this anomaly. The profitability premium might be easier to arbitrage away than the value or momentum effects because it is a low turnover strategy that can reduce volatility. Consequently, there is less career risk for professional money managers seeking to take advantage of it. While a manager may look incompetent with a portfolio of cheap companies that become cheaper (like J.C. Penney (NYSE:JCP)), poor performance may be more forgivable if he holds a portfolio of quality companies, such as IBM. But even if investors arbitrage away the profitability premium, highly profitable companies will likely continue to be less volatile than their less profitable counterparts. Therefore, a profitability tilt may still be worthwhile.
Of course, that doesn't mean it is sensible to pay any price for a profitable firm. In the early 1970s, investors pushed the prices of high-quality blue-chip growth companies, known as the "Nifty Fifty," above their fair values, which caused most of these stocks to underperform for many years. Investors who pay attention to both valuations and profitability will likely do better than those who focus more narrowly on either one.
In December, DFA launched its US Large Cap Growth (DUSLX) (0.2% expense ratio), US Small Cap Growth (DSCGX) (0.4%), International Large Cap Growth (DILRX) (0.3%), and International Small Cap Growth (DISMX) (0.55%) funds, which overweight growth stocks with strong profitability. While these funds do not impose a valuation discipline, they should offer better risk-adjusted returns than most traditional passive growth funds and may offer good diversification benefits for value-oriented investors. DFA is also planning to incorporate profitability into many of its other funds, including some of its value portfolios. However, these changes have not yet taken effect. Individual investors can gain access to DFA's funds only through a financial advisor.
Not to be outdone, AQR recently launched its Core Equity Fund (QCELX) (0.54% expense ratio), which incorporates value, profitability, and momentum into its portfolio construction process. AQR uses free cash flow/assets, gross profits/assets, and gross profit margins to measure profitability. Gross profits only deduct the cost of goods sold from sales. Unfortunately, some of the expenses that one firm lumps into cost of goods sold, another might classify as selling, general, and administrative expenses. This inconsistency can obfuscate comparisons across companies and industries. The free cash flow metric does not suffer from this problem. Similar to DFA, individual investors have access to this fund only through a financial advisor.
Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) (0.10% expense ratio) may be a suitable alternative for investors who don't have a financial advisor. While it doesn't directly screen for profitability, VIG targets firms that have increased their dividends in each of the past 10 years. This approach yields a portfolio of quality companies with strong profitability. Over the past year, the fund's holdings generated an average return on invested capital of 15.2%, while the corresponding figure for the S&P 500 Index was 12.8%. Additionally, a larger portion of VIG's portfolio is invested in companies with wide economic moats. IShares Russell Top 200 Growth Index (NYSEARCA:IWY) (0.20% expense ratio) offers an even stronger quality tilt than VIG, but its holdings trade at richer valuations, which may partially offset the benefit.
PowerShares S&P 500 High Quality (NYSEARCA:SPHQ) (0.29% expense ratio) also offers concentrated exposure to profitable companies. It invests in companies from the S&P 500 Index with above-average growth and stability of earnings and dividends over the most recent 10 years. Firms that score well on these metrics also tend to enjoy better than average profitability. Over the past year, the fund's holdings posted an average return on invested capital of 14.9%.
Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.