The new profitability factor, US and int'l evidence

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The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 7:56 am

http://www.indexuniverse.com/sections/features/18699-swedroe-profitablity-factor-a-new-trend.html

and here is the original piece I wrote when Novy-Marx published his paper, more detail than in the above link

http://www.cbsnews.com/8301-505123_162-57542953/a-new-way-to-be-a-value-investor/

Hope you find this of interest.

AQR has already come up with three new funds that are weighted 40% value, 40% MOM and 20% profitability--using a ranking system to select the stocks (and multiple screens for each of the factors). The three funds are US large, small and international.

DFA has already come out with three "growth" funds (though they aren't really growth funds, but profitability funds--though profitability predicts growth) and will be incorporating the profitability factor into their existing funds in the near future (continuing to screen for mom as well)

I would be very surprised given the power of the data if more funds are not created quickly to capture this factor. Pretty simple logic---holding value factor constant (say BtM or PE) firms with higher profitability have higher returns---and it turns out that high profitability predicts future profitability fairly well, there's a high degree of persistence which deteriorates some over time.

Note from what I've seen of the data, multiple value factors seem to capture some of this (vs say single BtM) because a factor like cash flow to price is a type of profitability factor and MOM is a growth type strategy--so combining them gets you some of that profitability factor ---and with MOM and Profitability negatively correlated to value adding these factors lowers volatility (drawdowns) and cuts tracking error.

I hope that is helpful

Best wishes

Larry
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Re: The new profitability factor, US and int'l evidence

Postby Random Walker » Tue May 14, 2013 9:11 am

A few questions:
Will a value fund that incorporates profitability and / or momentum be able to stay as "valuey"?

If a single fund incorporates value, profitability, momentum doesn't it risk becoming a fancy version of a plain vanilla whole market index fund that is more expensive?

If earnings quality and value are negatively correlated and there is a potential diversification benefit, will an individual investor using a value fund that incorporates profitability experience the benefit or does one need seperate value and profitability funds for rebalancing to experience the benefit?
Thanks,

Dave
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 9:58 am

Random Walker

1) once you add mom you will lose some HML loading, must happen as they are negatively correlated. Same thing true for profitability. The question then is does the premiums you gain and the negative correlation benefits outweigh the lower HmL loading and the answer appears to be a resounding yes, and you lower portfolio volatility, improve Sharpe ratio and lower tracking error risk.

2) as to looking like market--nope, huge difference as you load still on both value and profitability and gain the diversification benefits of their low correlation of the factors.

3) Better to be in one fund for same reasons a CORE fund is better than components---you save internal trading costs, cut turnover and the fund rebalances itself-

Best wishes
Larry
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Re: The new profitability factor, US and int'l evidence

Postby garlandwhizzer » Tue May 14, 2013 10:12 am

Let's see... the value factor is supposed to be more persistent and positive than the size factor or the market factor. However, recent evidence suggests that MOM, a growth factor, is also persistent and positive. Now we have another positive factor, profitability, associated with growth. So two factors, MOM and profitability, are correlated with growth and the value factor measured by B/M is correlated with its opposite. To me this sounds like a great advertisement for TSM, which is less expensive to employ, more tax efficient, more divesified, and includes all these factors as well as others to be "discovered" later. The more factor-associated funds one has, now 3 types, MOM, profitability, and value, two growth types and one value type, I suspect the more the portfolio looks like TSM. Although a heavily factor weighted portfolio seems to have outperformed in the past, I'll stick with tried and true TSM and dip my toe in the water of factors only slightly, if at all.

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Re: The new profitability factor, US and int'l evidence

Postby Scooter57 » Tue May 14, 2013 10:57 am

Is this supposed to be different from choosing an actively managed mutual fund that invests using a manager's secret sauce?
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Re: The new profitability factor, US and int'l evidence

Postby momar » Tue May 14, 2013 11:02 am

Larry, do you find it disturbing that fourth and fifth factors have now been added to a model that claimed all returns are explained by three factors? Especially when this study covered a period starting in 1998, a time well after the 3 factor model was known?

We can always come up with 'pretty simple logic' or a story behind why a particular factor seems to be meaningful. Humans are great at that.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 12:06 pm

Few thoughts
First it has nothing to do with active management. simply using the evidence from global data and long time periods to find factors that determine returns.
It then creates an "index" of the firms that fit the criteria and builds a fund that attempts to replicate the index without however strictly adhering to it because trading costs matter, so random tracking error is accepted. There is no active stock selection going on.


Second, the profitability factor takes firms with low prices relative to their profitability--so it's a clear value strategy--in fact it's Buffett's strategy (as identified in the paper discussed in my blog post here--http://www.cbsnews.com/8301-505123_162-57524029/how-warren-buffett-beats-the-market/,. It turns out however that profitability predicts growth. In other words it's simply a better value strategy. In fact it's basically similar to Greenblatt's secret sauce in his formula.

A portfolio using either an old school value portfolio (BtM only) would have outperformed TSM with great persistence, and funds that would have added MOM screening would have done even better and funds that would have adding profitability screens even better---in fact, the evidence suggests that value+ profitability is the source of Buffett's alpha.

So one can ignore the evidence, which is persistent, logical and consistent around the globe, or incorporate it.

Finally I would add this. I think we could all agree that Gene Fama is pretty smart guy. He thought that this profitability factor is the most exciting thing to come along in finance in long time.

Best wishes
Larry
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Re: The new profitability factor, US and int'l evidence

Postby Khanmots » Tue May 14, 2013 12:31 pm

momar wrote:Larry, do you find it disturbing that fourth and fifth factors have now been added to a model that claimed all returns are explained by three factors?

I'm not Larry, but since I've never seen a model that claimed all returns are explained by three factors, I don't find it disturbing.

I have seen models that claim that more of the return is explained by 3 factors than by one, but the model I saw was quite explicit about stating that it does not explain all return, just more.
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Re: The new profitability factor, US and int'l evidence

Postby momar » Tue May 14, 2013 12:40 pm

Khanmots wrote:
momar wrote:Larry, do you find it disturbing that fourth and fifth factors have now been added to a model that claimed all returns are explained by three factors?

I'm not Larry, but since I've never seen a model that claimed all returns are explained by three factors, I don't find it disturbing.

I have seen models that claim that more of the return is explained by 3 factors than by one, but the model I saw was quite explicit about stating that it does not explain all return, just more.

You're right, it is not all, it is over 90%.
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Re: The new profitability factor, US and int'l evidence

Postby hafius500 » Tue May 14, 2013 1:21 pm

larryswedroe wrote:Fund families such as Dimensional Fund Advisors and AQR have created funds that incorporate Novy-Marx’s findings, and it seems clear that more fund families are going to be looking for ways to isolate this profitability factor in the design of future products.


Societe Generale already constructed an investable quality index (tracked by, e.g., a Lyxor ETF)(*)

It could be a crowded trade at the moment:

Financial Times Videos (e.g., via youtube.com), Authors Note, John Authors - A good stock is hard to find (March 14, 1013) interviews Andrew Lapthorne, quantitative analyst at Societe Generale. SocGen offers the investable SocGen Global High Quality Income Index.
...this is a pretty stable universe and far more limited. Typically, we have 59 to 75 names...We have the lowest number of stocks that you can buy on that criterion for the last ten years.....


(*)
selected according to their dividend yields and subject to an additional quantitative screening for profitability, leverage, liquidity and operating efficiency...the index’s selection methodology also includes a market-based measure of balance sheet risk, called distance to default.
prior username: hafis50
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 1:59 pm

hafius
I am confident that everyone will construct their own measures here--some using simple gross profitability signals, others using multiple ones , some using single screens for MOM and others multiple and some using single value screens and others multiple

That Soc Gen index is much more concentrated at about 60-75 names then anything I've looked at with DFA, Bridgeway and AQR, with smallest being if memory servest 250

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Re: The new profitability factor, US and int'l evidence

Postby OverTheHill » Tue May 14, 2013 2:14 pm

Rubbish!
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Re: The new profitability factor, US and int'l evidence

Postby Elbowman » Tue May 14, 2013 2:25 pm

Since increased profitability doesn't seem like a risk I imagine it must be a behavioral phenomenon, but I don't see why people should be adverse to investing in profitable companies. Larry, do you have a feeling for why a profitability premium should persist?
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Re: The new profitability factor, US and int'l evidence

Postby Jebediah » Tue May 14, 2013 2:31 pm

Larry

Thanks for sharing. Two questions

1- So DFA's growth funds or AQR's momentum funds will differ from a vanilla growth fund (say VUG) in that they will have higher MOM and profitability factor loads and lower beta loads? Do you have the actual factor loadings for comparison?

2- How "crowdable" is this factor, how easily arbed away or not?
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Re: The new profitability factor, US and int'l evidence

Postby rmelvey » Tue May 14, 2013 2:33 pm

Larry,

What are your thoughts on Joel Greenblatt's "magic formula." It seems like one of the better attempts at combining quality and value into one ranking system.
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Re: The new profitability factor, US and int'l evidence

Postby Ged » Tue May 14, 2013 2:45 pm

momar wrote:Larry, do you find it disturbing that fourth and fifth factors have now been added to a model that claimed all returns are explained by three factors? Especially when this study covered a period starting in 1998, a time well after the 3 factor model was known?

We can always come up with 'pretty simple logic' or a story behind why a particular factor seems to be meaningful. Humans are great at that.


I would find either to be disturbing; the use of more than three factors or a claim that 3 factors explained all returns.
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Re: The new profitability factor, US and int'l evidence

Postby OverTheHill » Tue May 14, 2013 2:51 pm

It's called making it up as you go along. Just another pundit with a claim of knowing how to beat the market.
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Re: The new profitability factor, US and int'l evidence

Postby entyrii » Tue May 14, 2013 2:55 pm

This is an interesting and thought-provoking post. I am a new investor who started with (and currently still holds) a standard 3 fund portfolio and an appreciation for simplicity. I have recently become interested in more advanced investing concepts to add some juice to the portfolio over the long term so I started reading up on the FF 3-factor model and I have been working on ideas to implement a strategy to tilt towards small and value in my portfolio.

However, this article raises serious questions and causes me to doubt my quest for higher risk-adjusted returns beyond that of vanilla TSM. First there were 3 factors: beta, size, and value. Then, there was a new factor: momentum. Now the newest factor is profitability. So we're really living in a 5-factor world and the latest research will certainly unveil new factors in the future.

I realize that academic research will be ongoing and that there is no perfect theoretical explanation for investment returns and therefore the most cutting-edge "evidence-based" investing strategies will always be changing to incorporate the hottest new ideas. However, is not one of the cornerstones of our Boglehead investment philosophy to develop a solid strategy and stick to it through thick and thin? It seems that continuously changing one's strategy based on the newest research and hottest theoretical trends is contrary to this fundamental principle.

And what about that other Boglehead cornerstone, simplicity? An additional concern of mine is that as an investor searches for a means to capture these new factors, the less simple his portfolio becomes. I currently hold only three funds. In the tilted portfolio I was considering, I would end up with six or seven. A few years down the road, when we're living in a 9-factor world, how many funds would one need to capture all these factors? Larry would likely advocate entrusting your portfolio construction to experts at DFA and similar firms who can give you a core fund specially filtered to overweight these factors, but as an avid do-it-yourselfer and someone who has a vague suspicion of investment products of any type that are unnecessarily opaque or complicated, this simply does not appeal to me.

I will definitly put my portfolio transition plans on hold and I'll have to do some serious reading and thinking. Excellent post, Larry!
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Re: The new profitability factor, US and int'l evidence

Postby sperry8 » Tue May 14, 2013 2:59 pm

larryswedroe wrote:Few thoughts
First it has nothing to do with active management. simply using the evidence from global data and long time periods to find factors that determine returns.
It then creates an "index" of the firms that fit the criteria and builds a fund that attempts to replicate the index without however strictly adhering to it because trading costs matter, so random tracking error is accepted. There is no active stock selection going on.


Second, the profitability factor takes firms with low prices relative to their profitability--so it's a clear value strategy--in fact it's Buffett's strategy (as identified in the paper discussed in my blog post here--http://www.cbsnews.com/8301-505123_162-57524029/how-warren-buffett-beats-the-market/,. It turns out however that profitability predicts growth. In other words it's simply a better value strategy. In fact it's basically similar to Greenblatt's secret sauce in his formula.

A portfolio using either an old school value portfolio (BtM only) would have outperformed TSM with great persistence, and funds that would have added MOM screening would have done even better and funds that would have adding profitability screens even better---in fact, the evidence suggests that value+ profitability is the source of Buffett's alpha.

So one can ignore the evidence, which is persistent, logical and consistent around the globe, or incorporate it.

Finally I would add this. I think we could all agree that Gene Fama is pretty smart guy. He thought that this profitability factor is the most exciting thing to come along in finance in long time.

Best wishes
Larry


I like it! As soon as someone comes out with a fund that I can get without an advisor, I'm in. I don't want to hire an advisor just to get access to this (or any other DFA fund).
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Re: The new profitability factor, US and int'l evidence

Postby Jebediah » Tue May 14, 2013 3:03 pm

OverTheHill wrote:It's called making it up as you go along.


I know, stupid research, finding out new things all the time.
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Re: The new profitability factor, US and int'l evidence

Postby IlikeJackB » Tue May 14, 2013 3:10 pm

Let me see if I have this straight ..... they figured out that profitability matters?
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Re: The new profitability factor, US and int'l evidence

Postby OverTheHill » Tue May 14, 2013 3:10 pm

Jebediah wrote:
OverTheHill wrote:It's called making it up as you go along.


I know, stupid research, finding out new things all the time.

It's actually called data mining.
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Re: The new profitability factor, US and int'l evidence

Postby OverTheHill » Tue May 14, 2013 3:11 pm

IlikeJackB wrote:Let me see if I have this straight ..... they figured out that profitability matters?

Yes, and you get to pay a fee for that gem thank you very much.
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Re: The new profitability factor, US and int'l evidence

Postby rmelvey » Tue May 14, 2013 3:15 pm

It's funny how the academic community is still using the word "premiums" to describe these types of phenomenon. As if holding a cheap stock with profitability still requires a "premium." Couldn't it just be that Mr. Market isn't always the best at pricing securities?
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Re: The new profitability factor, US and int'l evidence

Postby swaption » Tue May 14, 2013 3:26 pm

rmelvey wrote:Larry,

What are your thoughts on Joel Greenblatt's "magic formula." It seems like one of the better attempts at combining quality and value into one ranking system.


Also my first thought. I would expect that Greenblat's book along with its somewhat provocative title would get treatment by folks on this board along the lines of raw meat being fed to a lion.
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Re: The new profitability factor, US and int'l evidence

Postby Clearly_Irrational » Tue May 14, 2013 3:38 pm

So I grabbed a breakdown from here (to save time): http://www.calculatinginvestor.com/2011/01/16/fama-french-etfs/

Code: Select all
Fund  Alpha     FF-Beta  FF-s (size)  FF-h (value)  R-squared
SPY   -0.087%   0.96    -0.13         0.012         0.986


So if the three factor model is explaining 98.6%, how much can momentum and profitability really be worth? Can someone post the five factor breakdown for SPY so that we can discuss it intelligently?
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Re: The new profitability factor, US and int'l evidence

Postby rmelvey » Tue May 14, 2013 3:39 pm

swaption wrote:
rmelvey wrote:Larry,

What are your thoughts on Joel Greenblatt's "magic formula." It seems like one of the better attempts at combining quality and value into one ranking system.


Also my first thought. I would expect that Greenblat's book along with its somewhat provocative title would get treatment by folks on this board along the lines of raw meat being fed to a lion.


So when Fama and French do quantitative screening to pick stocks its great, but when anyone else does it they get skewered as an evil active manager? Greenblatt's formula has been weighing quality and value before this research came out, and the metrics he choose to evaluate make sense.
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Re: The new profitability factor, US and int'l evidence

Postby momar » Tue May 14, 2013 3:45 pm

Clearly_Irrational wrote:So I grabbed a breakdown from here (to save time): http://www.calculatinginvestor.com/2011/01/16/fama-french-etfs/

Code: Select all
Fund  Alpha     FF-Beta  FF-s (size)  FF-h (value)  R-squared
SPY   -0.087%   0.96    -0.13         0.012         0.986


So if the three factor model is explaining 98.6%, how much can momentum and profitability really be worth? Can someone post the five factor breakdown for SPY so that we can discuss it intelligently?

It's certainly worth a lot to some people. I won't specify who.
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Re: The new profitability factor, US and int'l evidence

Postby swaption » Tue May 14, 2013 3:51 pm

rmelvey wrote:
swaption wrote:
rmelvey wrote:Larry,

What are your thoughts on Joel Greenblatt's "magic formula." It seems like one of the better attempts at combining quality and value into one ranking system.


Also my first thought. I would expect that Greenblat's book along with its somewhat provocative title would get treatment by folks on this board along the lines of raw meat being fed to a lion.


So when Fama and French do quantitative screening to pick stocks its great, but when anyone else does it they get skewered as an evil active manager? Greenblatt's formula has been weighing quality and value before this research came out, and the metrics he choose to evaluate make sense.


Just to be clear, I wasn't implying that such skewering would be warranted. Otherwise, I agree with you.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 4:08 pm

rmelvey
Greenblatt's model is very similar to the profitability model, though it is an "extreme portfolio" with small amount of holdings that no fund could run on and have a large amount of assets, it's not well diversified either. But the concept is the same. As to premiums--you appear to have misunderstood this. The fact that there is a premium doesn't rule out mispricing. The issue is a very different one--you can have a premium either because of a risk story or a mispricing (behavioral) or combination of both.

Few other thoughts
One snide comment was made about the discovery that profitability matters---it's not profitability, but profitability relative to market value---so firms with the same value metrics but having higher profitability (using gross profitability as the measure) have had higher returns. The question is is that an anomaly (market not pricing them right) or is it a risk story (as I mentioned, profitability predicts growth and thus more of the cash flows from high profitability are further into the future and thus more risky--discount them at higher rate--or you might argue that high profitability firms are more likely to attract competition and see their margins deteriorate--I"ve heard that story from a top finance professor).

I love comments like Overthehill's rubbish--some of the top financial economists in the world think this is the most important "discovery" in finance in long time, and overthehill knows better.

As to number of factors, first this is not a brand new issue. In fact I wrote about a new factor model that some are suggesting should replace the FF 3 factor model as it does a better job of explaining returns and addressing anomalies--which is a problem for the FF model. While the FF model does explain a high percentage of the differences in returns between diversified portfolios, there are many anomalies that go unexplained. Here's the paper
Kewei Hou, Chen Xue , Lu Zhang, “Digesting Anomalies: An Investment Approach,” September 2012 and here are the four factors
• The market excess return (MK T).
• The difference between the return on a portfolio of small-cap stocks and the return on a portfolio of large-cap stocks (rME). The size factor earns an average return of 0.31 percent per month and is statistically significant at the 5 percent level.
• The difference between the return on a portfolio of low-investment stocks and the return on a portfolio of high-investment stocks (R*A/A). The investment factor earns an average return of 0.44 percent per month and is statistically significant. It’s worth noting that the investment factor is highly correlated with the value premium (0.69), suggesting that this factor plays a similar role to that of the value factor.
• The difference between the return on a portfolio of high return on equity (ROE) stocks and the return on a portfolio of low return on equity stocks (rROE). The ROE factor earns an average return of 0.60 percent per month, and is statistically significant. Also of importance is that the rROE factor has very low correlation with the Fama-French factors. Thus, we can conclude that this factor provides important new information missing from the Fama-French model. In addition, it has a high correlation (0.50) with the momentum factor, meaning that rROE would play a similar role as the momentum factor in analyzing performance. They also found that the investment and return on equity factors are almost totally uncorrelated, meaning that they are independent, or unique, factors.

This model pretty much solves all the anomalies thus appears to be a better model than CAPM

What surprises me is the negative reactions. All models are by definition wrong. Researchers work to improve them. So we moved from the CAPM one factor beta world to a much better 3 factor model, clearly a superior model. Then a fourth factor MOM was added, improving on the FF model. And now basically academics appear to be in agreement that we can do better, adding profitability. Should we not try to learn more by examining data to learn how markets are pricing things. This factor for example now fully explains Buffett's alpha--it wasn't stock picking, but investing in this factor (plus the leverage from BRK).

What should matter is the following:
A) is the evidence logical
B) Is it persistent around the globe/across markets
c) can you access it (costs of implementation

I'll note that this is gotten some of the smartest people in the world of finance like Fama and French and Asness and Moskowitz very excited. And probably the most talked about new paper in finance is Novy-Marx's paper. The reason is that it meets all the criteria.

Jebediah
DFA's growth funds are not growth funds at all, that is misleading term and don't know why they chose it--well I do--at least IMO to give them a fund to market to institutions that want to fill in style boxes. But it's a profitability fund and adds momentum screens. I don't have the loadings and of course they will change over time anyway.
The market size is not an issue as it is there in the large space as well as small. And if it's risk story it cannot be arbed away (see my answer above) and if it's anomaly, doesn't matter you should buy the more profitable stocks anyway, as long as all else equal (p/e, or BtM) --that's simple math.

I hope this is helpful. Fine to be skeptical, but one should at least read the research and then make a judgment.
Best wishes
Larry
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 4:08 pm

rmelvey
Greenblatt's model is very similar to the profitability model, though it is an "extreme portfolio" with small amount of holdings that no fund could run on and have a large amount of assets, it's not well diversified either. But the concept is the same. As to premiums--you appear to have misunderstood this. The fact that there is a premium doesn't rule out mispricing. The issue is a very different one--you can have a premium either because of a risk story or a mispricing (behavioral) or combination of both.

Few other thoughts
One snide comment was made about the discovery that profitability matters---it's not profitability, but profitability relative to market value---so firms with the same value metrics but having higher profitability (using gross profitability as the measure) have had higher returns. The question is is that an anomaly (market not pricing them right) or is it a risk story (as I mentioned, profitability predicts growth and thus more of the cash flows from high profitability are further into the future and thus more risky--discount them at higher rate--or you might argue that high profitability firms are more likely to attract competition and see their margins deteriorate--I"ve heard that story from a top finance professor).

I love comments like Overthehill's rubbish--some of the top financial economists in the world think this is the most important "discovery" in finance in long time, and overthehill knows better.

As to number of factors, first this is not a brand new issue. In fact I wrote about a new factor model that some are suggesting should replace the FF 3 factor model as it does a better job of explaining returns and addressing anomalies--which is a problem for the FF model. While the FF model does explain a high percentage of the differences in returns between diversified portfolios, there are many anomalies that go unexplained. Here's the paper
Kewei Hou, Chen Xue , Lu Zhang, “Digesting Anomalies: An Investment Approach,” September 2012 and here are the four factors
• The market excess return (MK T).
• The difference between the return on a portfolio of small-cap stocks and the return on a portfolio of large-cap stocks (rME). The size factor earns an average return of 0.31 percent per month and is statistically significant at the 5 percent level.
• The difference between the return on a portfolio of low-investment stocks and the return on a portfolio of high-investment stocks (R*A/A). The investment factor earns an average return of 0.44 percent per month and is statistically significant. It’s worth noting that the investment factor is highly correlated with the value premium (0.69), suggesting that this factor plays a similar role to that of the value factor.
• The difference between the return on a portfolio of high return on equity (ROE) stocks and the return on a portfolio of low return on equity stocks (rROE). The ROE factor earns an average return of 0.60 percent per month, and is statistically significant. Also of importance is that the rROE factor has very low correlation with the Fama-French factors. Thus, we can conclude that this factor provides important new information missing from the Fama-French model. In addition, it has a high correlation (0.50) with the momentum factor, meaning that rROE would play a similar role as the momentum factor in analyzing performance. They also found that the investment and return on equity factors are almost totally uncorrelated, meaning that they are independent, or unique, factors.

This model pretty much solves all the anomalies thus appears to be a better model than CAPM

What surprises me is the negative reactions. All models are by definition wrong. Researchers work to improve them. So we moved from the CAPM one factor beta world to a much better 3 factor model, clearly a superior model. Then a fourth factor MOM was added, improving on the FF model. And now basically academics appear to be in agreement that we can do better, adding profitability. Should we not try to learn more by examining data to learn how markets are pricing things. This factor for example now fully explains Buffett's alpha--it wasn't stock picking, but investing in this factor (plus the leverage from BRK).

What should matter is the following:
A) is the evidence logical
B) Is it persistent around the globe/across markets
c) can you access it (costs of implementation

I'll note that this is gotten some of the smartest people in the world of finance like Fama and French and Asness and Moskowitz very excited. And probably the most talked about new paper in finance is Novy-Marx's paper. The reason is that it meets all the criteria.

Jebediah
DFA's growth funds are not growth funds at all, that is misleading term and don't know why they chose it--well I do--at least IMO to give them a fund to market to institutions that want to fill in style boxes. But it's a profitability fund and adds momentum screens. I don't have the loadings and of course they will change over time anyway.
The market size is not an issue as it is there in the large space as well as small. And if it's risk story it cannot be arbed away (see my answer above) and if it's anomaly, doesn't matter you should buy the more profitable stocks anyway, as long as all else equal (p/e, or BtM) --that's simple math.

I hope this is helpful. Fine to be skeptical, but one should at least read the research and then make a judgment.
Best wishes
Larry
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Re: The new profitability factor, US and int'l evidence

Postby OverTheHill » Tue May 14, 2013 4:14 pm

I repeat...rubbish. Why is it so popular for folks to say that eveyone with a brain agrees with them, when that simply is not the case.
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Re: The new profitability factor, US and int'l evidence

Postby momar » Tue May 14, 2013 4:18 pm

If this is so important, the story makes so much darn sense, and everyone in finance agrees, why in the world did it take 20 years from the publishing of FF to ID a factor related to profitability, of all things? And why have they only examined data starting in 1998?
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Re: The new profitability factor, US and int'l evidence

Postby Blues » Tue May 14, 2013 4:20 pm

I fear a new outbreak of the war of boring aggression... :oops:

(Or is it ignoring mean regression...? :confused )
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Re: The new profitability factor, US and int'l evidence

Postby momar » Tue May 14, 2013 4:23 pm

Larry, why do you call this a clear value strategy yet in your linked article call it a growth strategy?
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 4:49 pm

First, for those interesting you can read the very good book Quantitative Value by Gray & Carlisle

Momar, Your buying VALUE stocks but value stocks with a higher profitability --and higher profitability is to some degree predictable/persistent.
The data for Novy Marx paper goes back much further. For the newer paper looking at international data it only went back that far I guess because that is how far the accounting data was available for.


As to the credibility, Novy-Marx's paper, it was presented a while ago at the Q Group-- a leading group of the top thinkers in finance and papers are presented and debated by the group. This paper probably generated the most excitement about it of any in a long time according to people I know who where there. Here's the presentation he made there for those interested
http://www.q-group.org/pdf/Novy-Marx-TheOtherSideofValue-Slides.pdf

Overthehill
Since we all like to hear intelligent criticism so we can learn from it would be a great contribution if you can cite a paper or other criticism of the Novy-Marx work other than your statement of it's rubbish-which adds nothing of any value

Best wishes

Larry
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Re: The new profitability factor, US and int'l evidence

Postby Jebediah » Tue May 14, 2013 4:59 pm

From a distance, it does seem strange that these discoveries have taken so long to appear since the original Fama/French research. It would seem obvious to turn over all the rocks right away, run backtests on long-short portfolios based on every equity parameter imaginable and see if anything stood out. Was it an issue of data availability?
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 5:17 pm

jeb
Yes one would have thought so. And Buffett thought of it 50 years before the academics got around to it.
But should that mean you should ignore it, or that the evidence is any less valuable?
I do what I think intelligent people do, they follow the evidence, make sure it's logical and persistent around the globe and also look at implementation costs, trading and taxes and only then decide whether to incorporate the information--how to use it.

I've met recently with a number of professors and ex-professors of finance from the top schools and all have been very impressed with these findings. Everyone. And some where behavioral finance professors and others where more of the efficient markets/risk story side. And we've been reviewing the evidence now for quite a while (since the publication of Buffett's Alpha), and held many meetings with presenters as well. That's one of the benefits of an $18 billion + RIA, you get people's attention (:-))

Best wishes
Larry
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Re: The new profitability factor, US and int'l evidence

Postby OverTheHill » Tue May 14, 2013 5:18 pm

Since we all like to hear intelligent criticism so we can learn from it would be a great contribution if you can cite a paper or other criticism of the Novy-Marx work other than your statement of it's rubbish-which adds nothing of any value
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I'm not the one claiming to have found the new Holy Grail.
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Re: The new profitability factor, US and int'l evidence

Postby Jebediah » Tue May 14, 2013 5:31 pm

larryswedroe wrote:jeb
Yes one would have thought so. And Buffett thought of it 50 years before the academics got around to it.
But should that mean you should ignore it, or that the evidence is any less valuable?
I do what I think intelligent people do, they follow the evidence, make sure it's logical and persistent around the globe and also look at implementation costs, trading and taxes and only then decide whether to incorporate the information--how to use it.

I've met recently with a number of professors and ex-professors of finance from the top schools and all have been very impressed with these findings. Everyone. And some where behavioral finance professors and others where more of the efficient markets/risk story side. And we've been reviewing the evidence now for quite a while (since the publication of Buffett's Alpha), and held many meetings with presenters as well. That's one of the benefits of an $18 billion + RIA, you get people's attention (:-))

Best wishes
Larry


Thanks for the reply. Agreed, doesn't change the value of the evidence.
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Re: The new profitability factor, US and int'l evidence

Postby matjen » Tue May 14, 2013 5:52 pm

So Larry, what does this mean for your "Larry/Minimize Fat Tails" Portfolio? Are you going to wait for DFA to improve their funds/screens or are you adding the "growth" funds or is it too early?
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Re: The new profitability factor, US and int'l evidence

Postby sperry8 » Tue May 14, 2013 5:57 pm

OverTheHill wrote:Since we all like to hear intelligent criticism so we can learn from it would be a great contribution if you can cite a paper or other criticism of the Novy-Marx work other than your statement of it's rubbish-which adds nothing of any value
===========
I'm not the one claiming to have found the new Holy Grail.


OvertheHill, I wonder if you would've had the same reaction back in the day when the first paper came out showing a small value tilt increased returns? Perhaps you still don't believe that either?
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Re: The new profitability factor, US and int'l evidence

Postby nisiprius » Tue May 14, 2013 6:10 pm

larryswedroe wrote:...rmelvey
Greenblatt's model is very similar to the profitability model, though it is an "extreme portfolio" with small amount of holdings that no fund could run on and have a large amount of assets...
Meaning that the Formula Investing Funds don't actually follow the Formula?
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Re: The new profitability factor, US and int'l evidence

Postby grayfox » Tue May 14, 2013 6:15 pm

The reactions to this new research remind me of a book title Who Moved My Cheese?
Gott mit uns.
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Re: The new profitability factor, US and int'l evidence

Postby richard » Tue May 14, 2013 6:18 pm

Hi Larry,

"Profitability, as measured by gross profits-to-assets, has roughly the same power as book-to-market"

A problem with both of these measures is they rely on book. Book is more an accounting artifact than a measure of economic reality (for example, valuable assets can be carried at low amounts due to depreciation). Why should measures that rely on book work well? The traditional answer for btm is that anything to market works well, but btm works better.

p/e has a much better theoretical foundation (earnings are also subject to accounting games, but come a lot closer to representing economic reality). That metrics based on book work better than p/e or the like seems odd, and things that seem odd make me worry.

Any thoughts on this?

best,
Richard
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Re: The new profitability factor, US and int'l evidence

Postby DaveS » Tue May 14, 2013 6:44 pm

I spent several years getting used to "Value" stocks being the stocks of distressed companies, an exact quote from your first book. As a result it's going to take a while to embrace the concept that profitable, i.e. companies that are not distressed, will out perform. I think Marx may have been fooled by some statistical fluke such as unprofitable tech companies falling from way too lofty heights in 2000, rather than hitting on some long term predictor. Dave
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 6:52 pm

Richard
Nope, the profitability measure isn't against book value. And the evidence is strong that the more you go up the food chain to the top of the income statement the more you get stronger evidence. I've seen profitability as ROA as one metric, and profits to sales as another and free cash flow to assets as another. One can imagine others. AQR will be using a number of these metrics vs. a single one.

Overthehill
I'm not the one claiming to have found the new Holy Grail.

But you are the one that claims it's rubbish, but without any backup accept your opinion. And since we don't know your background (and not even willing to post your name) then we have no way of judging if that has any value whatsoever. And you offer no criticism showing why people like Fama and French and Asness and Moskowitz and Novy Marx (and Buffett and Graham and Dodd in effect), among the most respected people in all of finance, are all wrong and you, the noted and famous financial economist is correct. We now have several papers on the subject and at least for now no criticisms, just your rubbish comment. I wonder if you would be willing to stand up and debate this with someone like Fama or Novy Marx or is your comment limited to the anonymous nature of the Internet?

Nisiprius
I don't know Greenblatt's fund but I do know that his magic formula is for just 30 stocks. And The book Quantitative Value shows you can improve on his findings. IMO worth the read, but I guess that book is rubbish too (:-))

Hope that helps
Larry
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Re: The new profitability factor, US and int'l evidence

Postby richard » Tue May 14, 2013 7:24 pm

Larry,

What are they using as a measure of assets if not book value? You list the test as "Profitability, as measured by gross profits-to-assets"

ROA seems pretty much the same test.

Why gross profits rather than net income?

By higher on the income statement food chain do you mean top line (sales) or bottom line (net income). I'd assume net income.

Why should any of these be better than p/e?

I really prefer starting with a theory, then testing it. This appears to be a case of testing and picking the best results, without regard for underlying theory.

cheers,
Richard
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Re: The new profitability factor, US and int'l evidence

Postby Scooter57 » Tue May 14, 2013 7:26 pm

I still don't get why screening for stocks that meet this criteria, as I did with F.A.S.T. Graphs is active management and stock picking, while creating an index with the same criteria is passive investing.

An explanation in plain English, please!
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 7:45 pm

matjen
As to Larry Portfolio, DFA will be incorporating the data and Bridgeway in some way as well (there methodology may already be doing this as they incorporate Cash flow to price and sales to price as value metrics (which are profitability type measures) and not just BTM, and momentum is a profitability type factor as well. I will then look at how AQR portfolios fit. Given the huge K gains in my portfolio, not likely to sell anything but additions might be different and going forward recommendations might be different for new investors. Also tax management will matter for taxable accounts. AQR funds will have some tax management and DFA funds of course do for taxable accounts and so does Bridgeway,

Richard
profits to assets is not book value of the stock. And gross profits harder to manipulate, don't have things like accruals. Which is why it appears to work better.

AS to the rubbish comment. The simple equation I will show will show how why this is simple common sense. Don't need anything more than this equation
Expected Returns = Expected Cash Flows/Price

So if you have the same PRICE (market value) the firm with higher expected cash flows (higher profitability) must have higher expected returns. This is simple math--and certainly not rubbish.
The only question one might ask is what explains this---is there a reasonable risk story (as I posited above) or is it behavioral/mispricing? Why do more profitable firms have the same price?

But it doesn't matter, the math shows you get higher expected returns whatever the source.



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