The new profitability factor, US and int'l evidence

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

Postby richard » Tue May 14, 2013 8:52 pm

Larry,

How are you defining assets?

"In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset." http://en.wikipedia.org/wiki/Book_value
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Re: The new profitability factor, US and int'l evidence

Postby momar » Tue May 14, 2013 8:55 pm

larryswedroe wrote: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.

This is not a comment on the merit, but it is almost inconceivable to me that this was overlooked and is now viewed as a breakthrough.
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Re: The new profitability factor, US and int'l evidence

Postby rmelvey » Tue May 14, 2013 9:05 pm

Richard,

Book value is assets minus liabilities.
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Re: The new profitability factor, US and int'l evidence

Postby Uncle Buck » Tue May 14, 2013 9:33 pm

Tip from Uncle Buck..
Formulas, Calculations, and Graphs are a great way to predict past results.
your welcome
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Tue May 14, 2013 10:54 pm

momar
Might be surprising but it's true. Note however that there was whole school of Graham and Dodd and Buffett that invested this way, as did for example Greenblatt. This is we now know the source of their alpha (relative to the three factor model).
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Re: The new profitability factor, US and int'l evidence

Postby rmelvey » Tue May 14, 2013 11:47 pm

Larry,

Thanks for clearing that up about the premium. I guess the word "premium" makes me think of a reward for risk taking, but its good to know it can mean something else.

It's really funny how where I go now and talk with smart investors, Greenblatt always comes up! It's funny because his books always have the most ridiculous titles such as "You can be a stock market genius", or "Magic Formula Investing", but the theory and backtests are there. When you read about magic formula investing it is so simple and makes so much sense that you can't help but give yourself one of these :oops:

If I had a big enough portfolio I would think about doing my own quantitative value screens... one of these days :D
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Re: The new profitability factor, US and int'l evidence

Postby Clive » Wed May 15, 2013 6:11 am

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

Magic Formula is scalable. Whilst he suggests 20 to 30 stocks for most investors, he doesn't set a 30 upper limit, also he highlights how ranking 3500 stocks by deciles yields sequential best to worst results. Instead of buying 5 to 7 stocks each quarter, holding each for a year and repeating, in concept you might buy 5 each week, hold for a year and repeat... for a 260 set.

I'm uncertain as to whether Greenblatt's 30% annualised table contains duplicates. I suspect that average was obtained by taking 30 stocks each month and averaging all of those sets - within which the same stock might have appeared in multiple sets (some stocks weighted more than others).

Many if not all of the holdings in a small cap value filtered set would likely be holdings that you wouldn't individually pick. Typically they'll be stocks in out of favour sectors, or that have major company issues. A wide range of such stocks however will have some that rebound strongly, others that throw in the towel. From of set of 100, 90 might collectively average 0% - some a little up, others a little down, overall zip. 5 might totally fail, 5 might double - again overall zip. Or the few big winners might outweigh the big losers. However a big difference between small cap growth and small cap value is the book-value. For SCV the price to book value is often 1.0 or less, which means that for those that do fail, the loss might be relatively little (some might even be broken up for a profit). SCG in contrast will often be carrying higher debts than assets and as such result in 100% loss. If 5 throw in the towel and average 0% loss, 5 double in value and 90 break-even, you're 5% up overall (compared to SCG perhaps being 0% overall).

That characteristic of few losers being outweighed by few big winners runs somewhat independently from the rest of the market, and as such is a useful diversifier. The wider market might be down, but a few depressed stocks might overcome their difficulties and rebound strongly in price/valuation no matter what the rest of the market might be doing.
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Re: The new profitability factor, US and int'l evidence

Postby beammeupscotty » Wed May 15, 2013 6:45 am

larryswedroe wrote: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.


What are the chances that Vanguard will create/update funds for this?
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Re: The new profitability factor, US and int'l evidence

Postby Clive » Wed May 15, 2013 7:20 am

Clive wrote:Many if not all of the holdings in a small cap value filtered set would likely be holdings that you wouldn't individually pick. Typically they'll be stocks in out of favour sectors, or that have major company issues. A wide range of such stocks however will have some that rebound strongly, others that throw in the towel. From of set of 100, 90 might collectively average 0% - some a little up, others a little down, overall zip. 5 might totally fail, 5 might double - again overall zip. Or the few big winners might outweigh the big losers. However a big difference between small cap growth and small cap value is the book-value. For SCV the price to book value is often 1.0 or less, which means that for those that do fail, the loss might be relatively little (some might even be broken up for a profit). SCG in contrast will often be carrying higher debts than assets and as such result in 100% loss. If 5 throw in the towel and average 0% loss, 5 double in value and 90 break-even, you're 5% up overall (compared to SCG perhaps being 0% overall).

Migration : Eugene F. Fama and Kenneth R. French

Bottom Line

Our results on how migration leads to the size and value premiums in average returns are easily summarized. The size premium is due almost entirely to the extreme positive returns of small stocks that move to a big stock portfolio from one year to the next. Three factors contribute to the value premium. (i) Plus transitions, with their high returns, occur more often for value stocks than for growth stocks. (ii) Minus transitions and their low returns are more likely for growth stocks. (iii) Value stocks that remain in the Same portfolio from one year to the next have higher average returns than the matching (small or big) growth stocks.
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Re: The new profitability factor, US and int'l evidence

Postby richard » Wed May 15, 2013 7:37 am

rmelvey wrote:Book value is assets minus liabilities.

I've been using book value in the accounting sense (as should have been clear from my posts):

"In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset." http://en.wikipedia.org/wiki/Book_value

In any event, profitability is apparently taking asset value from the balance sheet, in which case that are using original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. This number is much more of an accounting artifact than an economically significant number.

I continue to ask whether the profitability researchers had an underlying theory they tested, or whether they were just rooting around the data mines and happened upon a fortuitous result. If so, what was the theory? If they are using accounting asset value, it's harder to believe there is an underlying theory.
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Re: The new profitability factor, US and int'l evidence

Postby gt4715b » Wed May 15, 2013 8:29 am

richard wrote:I've been using book value in the accounting sense (as should have been clear from my posts):

"In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset." http://en.wikipedia.org/wiki/Book_value

In any event, profitability is apparently taking asset value from the balance sheet, in which case that are using original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. This number is much more of an accounting artifact than an economically significant number.

I continue to ask whether the profitability researchers had an underlying theory they tested, or whether they were just rooting around the data mines and happened upon a fortuitous result. If so, what was the theory? If they are using accounting asset value, it's harder to believe there is an underlying theory.


I think Larry mentions the basic theory earlier in the thread.

Regarding your other point, he uses what he calls "gross profitability" which he says a better proxy than accounting earnings. Here is a fragment from the original paper that I think gets at what you were saying:

Gross profits is the cleanest accounting measure of true economic profitability. The farther down the income statement one goes, the more polluted profitability measures become, and the less related they are to true economic profitability.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Wed May 15, 2013 8:43 am

beammeupscotty

Vanguard certainly could, don't know if they will. They tend to stick with simple INDEXES as a retail oriented firm.

Richard
The explanation of why it works is simple math, in the equation I gave. Book value is net asset value, assets minus liabilities, not asset value. Now of course it's also net asset value in the sense of accounting for depreciation.

As I noted Graham and Dodd provided the theory decades ago, as did Buffett. All else equal buying company with more profitability should result in higher returns. The question you can logically ask is why do companies with higher profitability sell at same valuations as companies with lower profitability. I tried to provide some answers from a risk standpoint, but one might argue it's just a behavioral mistake. Either way it's simple math

I hope that helps
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Re: The new profitability factor, US and int'l evidence

Postby OverTheHill » Wed May 15, 2013 8:52 am

larryswedroe wrote:Vanguard certainly could, don't know if they will. They tend to stick with simple INDEXES as a retail oriented firm.

I hope that helps
Larry

[Inflammatory comment removed by admin LadyGeek]
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Re: The new profitability factor, US and int'l evidence

Postby matjen » Wed May 15, 2013 9:14 am

OverTheHill wrote:[Inflammatory comment removed by admin LadyGeek]


Saying something is one thing OverTheHill, proving it is another. Perhaps a little more of an open mind would do you some good. This almost seems like a religious issue for you. I currently have a sliced n'diced n'tilted portfolio that utilizes only indexes and etfs that are all low cost (Vanguard, Schwab & Fidelity) but I must say I am intrigued by these "value-add" fund companies. Also, this board would be a pretty boring place if people like Larry, Rick, William Bersnstein, Allen Roth, Bill Schultheis and the various DFA advisors,etc. didn't chime in with their perspective. I am very, very appreciative regardless of whether I use their services.
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Re: The new profitability factor, US and int'l evidence

Postby Gauntlet » Wed May 15, 2013 9:25 am

garlandwhizzer wrote: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.

Garland Whizzer


+1 Well said!

All these factors are very interesting and I love reading about them but at some point there are just too many ways to slice and dice. Not to mention, the majority of savers would have to balance all these factors over several accounts. Yikes. And never forget that there is no free lunch. Tilting to any of the numerous factors increases the portfolio's risk.
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Re: The new profitability factor, US and int'l evidence

Postby Roy » Wed May 15, 2013 9:32 am

OverTheHill wrote:[Inflammatory comment removed by admin LadyGeek]


Vanguard is not just about selling indexing and carries many fund families, but they do charge a transaction fee to access some of them. I believe AQR's 3 funds that apply this strategy (Domestic Large and Small,and one International fund) can be acquired through Vanguard (with no advisor). I typed in the 3 tickers from the AQR site and they were each available. I need to re-check the boilerplate, though.

I believe when Vanguard first launched their index funds, they were similarly regarded as a sort of "rubbish: "Bogle's Folly;" "un-American," etc. Then progress happened.

Regarding the new funds, we'll see how they do. But the evidence that inspired their creation is hardly new.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Wed May 15, 2013 9:47 am

overthehill wrote:[Inflammatory comment removed by admin LadyGeek]

1) [Response to inflammatory comment removed by admin LadyGeek (also fixed quote)]

2)As to your other comment--it's Vanguard's choice to stick with simple index funds because they choose to do so---now that comes with a price to it's investors in tax inefficiencies, lower returns and higher trading costs. They clearly could choose to offer products that seek to minimize/eliminate the negatives of indexing. But they have chosen not to, There are plenty of funds that don't require advisors that also use strategies that improve on pure indexing based on popular retail indices. DFA on other hand by not making their funds available to retail investors doesn't have to deal with individual investors and explaining to them why their funds have massive tracking errors in some years--no 800 lines to man and manage, and thus lot lower expenses than they would have if ran a retail fund. In other words it's a business decision by both firms.

Richard and others
The key insight that was found in the research is that profitability is persistent, though the persistence declines over time. But still if my memory serves after even 5-7 years more than half the firms that had higher profitability in year one had higher profitability in the later years. Along with that is that profitability predicts growth.
Hope that helps.

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

Postby dmcmahon » Wed May 15, 2013 10:01 am

momar wrote:
larryswedroe wrote: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.

This is not a comment on the merit, but it is almost inconceivable to me that this was overlooked and is now viewed as a breakthrough.


I think the expected part of that is where one could get tripped up. With old-fashioned metrics such as BtM you don't have to rely on forecasts, you only need current/trailing data. A lot of companies were very profitable before their businesses turned - check out the nifty 50 from the 1960s. You can see this same tension when people argue about how expensive the market is based on forward P/E ratios (implicitly forecasting E) versus TTM P/E or Shiller P/E. It also doesn't help that there's a lot of play in the numbers. P is observable, but E is subject to a lot of accounting vagaries. Even "book value" is fuzzy if it includes goodwill and other such items - at least there, you can appeal to so-called "tangible book value". The challenge is to conjure up some observable and impartial metrics that are correlated with the expected cash flows.
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Re: The new profitability factor, US and int'l evidence

Postby OverTheHill » Wed May 15, 2013 10:02 am

2)As to your other comment--it's Vanguard's choice to stick with simple index funds because they choose to do so---now that comes with a price to it's investors in tax inefficiencies, lower returns and higher trading costs. They clearly could choose to offer products that seek to minimize/eliminate the negatives of indexing. But they have chosen not to, There are plenty of funds that don't require advisors that also use strategies that improve on pure indexing based on popular retail indices. DFA on other hand by not making their funds available to retail investors doesn't have to deal with individual investors and explaining to them why their funds have massive tracking errors in some years--no 800 lines to man and manage, and thus lot lower expenses than they would have if ran a retail fund. In other words it's a business decision by both firms.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Wed May 15, 2013 10:40 am

overthehill
[Inflammatory comment removed by admin LadyGeek]


[Response to inflammatory comment removed by admin LadyGeek]

If anyone thinks that spending time on a board for DIYers is going to be a productive use of their time in terms of drumming up business they have no clue about what they are talking about. As to attacking, providing the evidence demonstrating a statement is incorrect isn't attacking, it's having a discussion. Nowhere in this discussion have I attacked anyone. And I have received many emails from diehard's commending me on my incredible patience in trying to explain and issue. But of course even I have limits to my patience. Instead the comments like rubbish are the attacks. Personally I don't have any agenda, whatever you believe, other than to help investors by providing them with the information needed to make intelligent decisions. And I believe this to be true of all the professionals who post here. Especially those that aren't among the lowest cost investment advisors.

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

Postby Rodc » Wed May 15, 2013 10:45 am

1) Still waiting for us to hear your brilliant insights explaining why the work on profitability is rubbish. The economic explanations which will also provide us the insights into why such investors as Graham and Dodd and others like Buffett also preached rubbish--because this is basically the strategy they have used to deliver market beating returns.


I'm not entirely opposed to new insights, in the fullness of time some might even turn out to be actual insights. I don't have any great data for you on this, so no point in asking. I would just caution that great skepticism of new "market beating" strategies (your phrase), which arise almost continually have a poor record of performance. Even when put forth by well known experts. I would suggest no one should feel compelled to simply believe based on a crop of new papers, since this has not always worked out well in the past. At the time of the new insight it might not be clear why they are going to fail, that understanding comes later after the fact.

Value and small have reasonable if not bomb-proof risk stories. They have going on 20 years or something live histories. Some hope they represent something real. I have been using them for sometime. But that only has a hope if the strategy is pursued long term. No one will be well served if they jump every few years to reset strategy based on the latest breaking news.

It is worth considering that academics are under great pressure to continually publish (exciting!) new finding whether they really are sound or not. It is simply the name of the game. Again, great skepticism is the watch word. Especially if phrases like "strategy ... to deliver market beating returns" are used.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Wed May 15, 2013 10:50 am

Rod
Completely agree, One should be skeptical that any evidence isn't result of data mining or data snooping

That is why before acting one should be sure that the evidence is
A) logical story behind the evidence
B) persistent across the globe and asset classes
C) is implementable in live portfolios--meaning trading costs don't eat up any "excess" profits

Note again, this isn't really a new story--certainly Graham and Dodd preached it for decades before the academics "discovered" it. And having reviewed the literature I believe it meets the three tests I outlined

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

Postby pkcrafter » Wed May 15, 2013 11:06 am

Seems to me that active managers have known this all along. After all, profitability has always been a major criterion for stock selection.

Larry, I think that investors like the 3 factor model--it is elegant and makes sense in explaining ~90% of returns. When you add momentum it sounds a bit like riding the wave of performance chasing. Then when you bring in profitability it sounds like old ground rediscovered. Are we really looking at two new factors that account for most of the remaining 10% of returns not explained by 3-factors? At the very least, it will take some FF followers time to digest these ideas because they may feel the line has been crossed from high-tech indexing strategies to active management. DFA may actually run the risk of putting off potential clients who want to index.


Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
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Re: The new profitability factor, US and int'l evidence

Postby Ranger » Wed May 15, 2013 11:10 am

+1
Drum up business, even accusing other successful firms are doing something illegal without offering any proof.

viewtopic.php?f=10&t=110296&p=1605993#p1605993

OverTheHill wrote:2)As to your other comment--it's Vanguard's choice to stick with simple index funds because they choose to do so---now that comes with a price to it's investors in tax inefficiencies, lower returns and higher trading costs. They clearly could choose to offer products that seek to minimize/eliminate the negatives of indexing. But they have chosen not to, There are plenty of funds that don't require advisors that also use strategies that improve on pure indexing based on popular retail indices. DFA on other hand by not making their funds available to retail investors doesn't have to deal with individual investors and explaining to them why their funds have massive tracking errors in some years--no 800 lines to man and manage, and thus lot lower expenses than they would have if ran a retail fund. In other words it's a business decision by both firms.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Wed May 15, 2013 11:45 am

Paul
Few thoughts for you

Three factor model does a wonderful job, but it failed to explain the existence of many anomalies, including MOM. That is why MOM was added as a fourth explanatory factor

Recently there has been a lot of research including papers I have written about that show that other models using other factors provide similar explanatory power to the FF model but explain the anomalies well. Thus they are better models. There now appears to be competition for which is the best model. And just as the CAPM was subplanted it now seems likely that the FF model could be supplanted.

The best paper on the subject IMO is the 2012 paper, “Digesting Anomalies: An Investment Approach,” http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2152674
It proposed a four factor model which perhaps you'll like better (:-)) as it doesn't include MOM though it does include profitability. Here's the model.


• 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.

As to active managers knowing this all along. Clearly some did. But if they all did why didn't they outperform?

Personally I don't see how anyone can claim that this is active management any more than DFA was doing before. They are simply following the evidence when it's logical, persistent and implementable--which is what they have always done. Also I don't see why anyone should prefer to index (meaning pure index) if one doesn't start off with any preconceived notions. Clearly there are some negatives to pure indexing which can be avoided/minimized. Depending on the asset class the differences can be small or minor. But just look at the R2k for example as a god awful disaster for those that indexed, including Vanguard investors who suffered until Sauter got them to change indices. That cost investors about 2% a year. Indexing does have the benefit of simplicity, but that doesn't make it optimal

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

Postby swaption » Wed May 15, 2013 11:52 am

larryswedroe wrote:momar
Might be surprising but it's true. Note however that there was whole school of Graham and Dodd and Buffett that invested this way, as did for example Greenblatt. This is we now know the source of their alpha (relative to the three factor model).
Larry


But here is the problem. By my count we now have five factors, but only two of them have associated risk that can be rigorously verified. Sure you have "value risk" in a theoretical sense, but given the number of theories and the lack of hard evidence, one can't dismiss a purely behavioral story. The problem is, absent commensurate risk, you basically end up with a low cost means of fundamental analysis. It actually startes becoming somewhat ridiculous and circular. The premise is that these various factors enable above market returns, but even though there is no evidence of increased risk, it must be there because we are not supposed to believe that is possible to achieve above market returns without increased risk. At a certain point, even the academics have to come clean that this is all an active management approach alleged to provide sytematically higher returns. Maybe they'll lose tenure, but perhaps they'll make it back elsewhere in the form of management fees.
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Re: The new profitability factor, US and int'l evidence

Postby camontgo » Wed May 15, 2013 12:07 pm

swaption wrote:The problem is, absent commensurate risk, you basically end up with a low cost means of fundamental analysis.


I agree. IMO, the profitability factor has compelling data, and it makes sense from a "fundamental" perspective, but not from a "risk" perspective.

I'm reminded of the once very popular "accruals anomaly" originally published by Sloan in 1996. It was very large in the historical data, and it worked well until everyone started trying to exploit it...which I think should be expected for any similar accounting based anomaly which has no link to risk.

Accruals anomaly history: http://papers.ssrn.com/sol3/papers.cfm? ... id=1501020
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Re: The new profitability factor, US and int'l evidence

Postby rmelvey » Wed May 15, 2013 12:21 pm

camontgo wrote:
swaption wrote:The problem is, absent commensurate risk, you basically end up with a low cost means of fundamental analysis.


I agree. IMO, the profitability factor has compelling data, and it makes sense from a "fundamental" perspective, but not from a "risk" perspective.

I'm reminded of the once very popular "accruals anomaly" originally published by Sloan in 1996. It was very large in the historical data, and it worked well until everyone started trying to exploit it...which I think should be expected for any similar accounting based anomaly which has no link to risk.

Accruals anomaly history: http://papers.ssrn.com/sol3/papers.cfm? ... id=1501020


Exactly. This is quantitative stock picking at a low cost. Which doesn't mean that it's garbage, but to demonize people like Greenblatt and other active value guys and then praise Fama and French for doing it is a symptom of drinking a little too much DFA kool-aid.
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Re: The new profitability factor, US and int'l evidence

Postby Clearly_Irrational » Wed May 15, 2013 12:32 pm

The idea that beaten down companies that are still profitable are good investments isn't controversial to me. I do find it amusing however that the statistical models seem to be heading towards the way I used to invest actively.

Does anyone have any data on the size and volatility of the momentum and profitability premiums?
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Re: The new profitability factor, US and int'l evidence

Postby scone » Wed May 15, 2013 12:57 pm

Thank you, Larry, interesting food for thought! Could this factor help explain why Wellesley and Wellington have done so well for so long? At least, I think of Wellington Management as being in the Graham and Dodd tradition.
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Re: The new profitability factor, US and int'l evidence

Postby hafius500 » Wed May 15, 2013 1:40 pm

Some articles about the Novy-Marx paper and Greenblatt's Magic Formula:
Wesley Gray (Turnkeyanalyst) and Tobias Calisle (Grennbackd) are the authors of the book 'Quantitative Value' that larryswedroe mentioned. They are quant investors who do not believe in efficient markets and advocate a 'profit and value strategy'.
I still don't see the theory that explains why this 'profitability factor' is not an anomaly that may disappear or persist. OTOH, quant investors don't need persistent factors like academics who relate factors to rational explanations (risk). They are free to acccept or reject any strategy tomorrow.
Greenbackd - An examination of the “Profit and Value” strategy
The actual “Gross Profitability” factor Novy-Marx uses is as follows:
Gross Profitability = (Revenues – Cost of Goods Sold) / Total Assets

Greenbackd quotes Novy-Marx:
I scale gross profits by book assets, not book equity, because gross profits are not reduced by interest payments and are thus independent of leverage.

Dicussion about the novy-Marx paper and Greenblatt's Magic Formula below the article.

Greenbackd - How to find high quality stocks, March 4, 2013 by Tobias Carlisle
Robert Novy-Marx, whose The Other Side of Value paper we quoted from extensively in Quantitative Value, has produced another ripping paper called The Quality Dimension of Value Investing (.pdf). Novy-Marx argues that value investment strategies that seek high quality stocks are “nearly as profitable as traditional value strategies based on price signals alone.”

Quote Novy-Marx:
Accounting for both dimensions by trading on combined quality and price signals yields dramatic performance improvements over traditional value strategies. Accounting for quality also yields significant performance improvements for investors trading momentum as well as value.


Empirical Finance Blog/ Turnkeyanalyst - The Other Side of Value, Posted on February 19, 2011 by wes discusses the paper:
The period analyzed is from July 1963 to December 2009...An asset purchased for $100 that produces terds is probably overvalued at 1 penny, whereas an asset purchased for $100 that produces golden nuggets is probably undervalued at 100x book. The main point is that not all assets are created equal and looking at book values doesn’t always tell you the entire value story....To address the concerns about liquidity and size constraints, the author looks at a profitability factor and B/M strategy that only trades in the largest stocks (top 500, ex financials). Specifically, at the end of each June, he buys the top 150 stocks with the highest average of profitability and B/M, and shorts the bottom 150 stocks with the lowest average profitability and B/M


Empirical Finance Blog/ Turnkeyanalyst - More Magic Formula Analysis, Posted on June 7, 2011 by wes
[We] can’t replicate the results under a variety of methods....[It] is obvious that ‘magic small-caps’ are driving the backtested performance here[2009-10]. As one can see, the live magic formula dramatically underperforms the backtested performance (likely because they had limited small/mid cap exposure).
Although anecdotal in nature, we can see from a very limited out of sample test (2009 and 2010) that the backtest returns to a Magic Formula strategy is VERY unstable and results should be analyzed with a skeptical eye.”
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Re: The new profitability factor, US and int'l evidence

Postby Roy » Wed May 15, 2013 1:41 pm

scone wrote:Could this factor help explain why Wellesley and Wellington have done so well for so long? At least, I think of Wellington Management as being in the Graham and Dodd tradition.


Hi, Scone,

Agreed this has been a good topic.

It is true that Wellington management targets undervalued stocks that have good prospects for improvement (possibly due to intrinsic "quality"); Vanguard itself refers to these as "value stocks" when describing Wellington, and many of those are dividend payers, (and moreso with Wellesely). But much of their success (if not all) can be explained by simple asset allocation to Value indexes and some fixed combo of mid-long term Treasuries and Corporates. This is not surprising when you consider Larry's discussions on dividend paying stocks as being explained largely by their Value bent.

Considering Wellington holds about 35% bonds and Wellesley about 65%, the decades-long Bond Bull market helped enormously in the last few decades. Their massive allocation to bonds are a bit of a confounding variable in an analysis focusing on equities, though the funds are certainly popular.
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Re: The new profitability factor, US and int'l evidence

Postby umfundi » Wed May 15, 2013 1:51 pm

The "secret sauce" analogy is good. Choose one:

1. There is no secret sauce
2. There is a secret sauce, but we have 90% of the ingredients - good enough
3. Only Warren Buffet knows the other 10% of the ingredients
4. We figured out the other 10%, but the recipe is too complicated to make at home - only the finest chefs can make it
5. If we know the ingredients, it's not a secret - go to item 1

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

Postby RNJ » Wed May 15, 2013 2:23 pm

Here is the AQR Core Equity Fund Class N (QCENX). The "N" stands for NOT with respect to having the $5 Million minimum for the less expensive, presumably institutional class shares.

From the Vanguard site:

Large Value
Expense ratio as of 05/01/2013: 1.12%
Inception date 03/26/2013
Ticker symbol QCENX
12b-1 fee: .25%

Number of Stocks 244
Median Market Cap $22.7 billion
Price/Earnings Ratio 14.0x
Price/Book Ratio 1.7x
Earnings Growth Rate —
Foreign Holdings 0.1%
Turnover Rate (Fiscal Year End) —
Total Net Assets as of 04/30/2013 $1.1 million


Any takers?

Oh - did I mention that the top holding was good ol' Berkshire Hathaway Class B?
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Wed May 15, 2013 2:35 pm

swaption

You don't need a risk theory to explain any of this as I said. All you need is the cost of capital story.
If you have two companies that have the same valuation and one is more profitable, and profitability persists, then you have higher expected returns. That's simple math, nothing more. And the data shows that profitability persists.

Now you can buy the behavioral story or you can buy the risk story (gave a few possible explanations) but it's irrelevant, it's simple math, just as it is in the value story--it's cost of capital,whether mispricing or risk. If you think it's behavioral then you have to decide if you think it will persist. If yes, then no problem, if no, then best to buy these stocks now anyway and you'll benefit as the market reprices.
If it's risk story, then you have to decide if it's worth the risk, do you have the abililty, willingness and need to take the risks.

I hope that is helpful
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Re: The new profitability factor, US and int'l evidence

Postby EntropyInvestor » Wed May 15, 2013 2:58 pm

I have a few issues with this new profitability measure.

1) Gross Profits/Assets is a financial measurement of the company, NOT the stock. This ratio should be divided by either market cap or enterprise value in order to incorporate how the market is pricing the stock.

2) Economies of Scale…….Stocks with greater market caps should have a greater Gross Profit/Assets ratio relative to stocks with smaller market caps because of economies of scale. Greater production tends to reduce the average total costs which would increase this new profitability measure.

3) The capital structure across industries varies significantly. Some industries have lower Gross Profits than others because of high Cost of Goods Sold (ex. Materials and Energy). Industries like Technology have higher Gross Profits because of lower Cost of Goods Sold, instead have higher Operating Expenses. The same can be said about the second part of the ratio in the use of Assets. To support my point, Novy-Marx’s research excludes all Financials because they have very low Cost of Goods Sold and very high Assets, making Financials seem extremely productive. In Larry Swedroe’s column on Index Universe, notice all the variations of measuring a company’s income…Net Income, EBITDA, FCF, EBIT, Operating Income and Gross Profit. Each variation of income favors one industry over another.
http://www.indexuniverse.com/sections/s ... equal.html


Implementing Gross Profits/Assets in a portfolio will increase turnover and fees. Enhanced indexes should use combinations of broad valuation measurements that have low correlation between each other. For example: (Market Cap / Book Value)*(Enterprise Value / Net Income)*(6 Month Total Return)
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Re: The new profitability factor, US and int'l evidence

Postby Roy » Wed May 15, 2013 3:10 pm

RNJ wrote:Here is the AQR Core Equity Fund Class N (QCENX). The "N" stands for NOT with respect to having the $5 Million minimum for the less expensive, presumably institutional class shares.

From the Vanguard site:

Large Value
Expense ratio as of 05/01/2013: 1.12%
Inception date 03/26/2013
Ticker symbol QCENX
12b-1 fee: .25%

Number of Stocks 244
Median Market Cap $22.7 billion
Price/Earnings Ratio 14.0x
Price/Book Ratio 1.7x
Earnings Growth Rate —
Foreign Holdings 0.1%
Turnover Rate (Fiscal Year End) —
Total Net Assets as of 04/30/2013 $1.1 million


Any takers?

Oh - did I mention that the top holding was good ol' Berkshire Hathaway Class B?


Thanks, RNJ. Unless I'm missing something, the Fees and Minimums are $1,000,000 for QCENX for initial investment. The top holdings do appear to be many of the usual "quality" suspects in a GMO (and others) sense. How they use Momentum to guide them is another thing.
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Re: The new profitability factor, US and int'l evidence

Postby matjen » Wed May 15, 2013 3:28 pm

Roy wrote:Thanks, RNJ. Unless I'm missing something, the Fees and Minimums are $1,000,000 for QCENX for initial investment. The top holdings do appear to be many of the usual "quality" suspects in a GMO (and others) sense. How they use Momentum to guide them is another thing.


FWIW, Fidelity appears to let me buy it. I tried to place a 9K order and it went to the preview stage and told me there was a $75 fee for it but it did let me place the trade if I wanted to.

Action Buy
Symbol QCENX
Description AQR CORE EQUITY FUNDCLASS N
Amount $9,000.00
Trade Type Cash
Estimated value of this order without fee: $9,000.00
Estimated transaction fee: $75.00
View No-Fee Mutual Funds in the same investment category.
The estimated value of this order with fee: $9,075.00
By clicking Place Order, you consent to receive the prospectus electronically.
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Re: The new profitability factor, US and int'l evidence

Postby Roy » Wed May 15, 2013 3:48 pm

matjen wrote:
Roy wrote:Thanks, RNJ. Unless I'm missing something, the Fees and Minimums are $1,000,000 for QCENX for initial investment. The top holdings do appear to be many of the usual "quality" suspects in a GMO (and others) sense. How they use Momentum to guide them is another thing.


FWIW, Fidelity appears to let me buy it. I tried to place a 9K order and it went to the preview stage and told me there was a $75 fee for it but it did let me place the trade if I wanted to.

Action Buy
Symbol QCENX
Description AQR CORE EQUITY FUNDCLASS N
Amount $9,000.00
Trade Type Cash
Estimated value of this order without fee: $9,000.00
Estimated transaction fee: $75.00
View No-Fee Mutual Funds in the same investment category.
The estimated value of this order with fee: $9,075.00
By clicking Place Order, you consent to receive the prospectus electronically.


Thanks, Matjen (I like your Billy Jack avatar). Just spoke directly to Vanguard Brokerage. QCENX is $1,000,000 Initial (no transaction fee). And the lower expense QCELX is $5,000,000, with a transaction Fee based on Brokerage status—$35.00 down to $8.00.
Last edited by Roy on Wed May 15, 2013 3:51 pm, edited 1 time in total.
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Re: The new profitability factor, US and int'l evidence

Postby learning_head » Wed May 15, 2013 3:50 pm

So, as Clearly_Irrational noted, FF "explained" 98.6% of the returns. Larry indicates now there is a better set of factors that explains some "anomalies" in FF model and therefore is "better" in some sense. Question is: for investors that bought into 3-factor investment for the long term (either some time ago or just recently), should they now switch to the new factor based investments (once funds become available to them)? Would that ruin their "long-term" plan that called for potentially decades of underperformance / tracking (vs tsm) error? For younger investors, I imagine, in another 20 years there will be yet another model - would they switch at that point as well? How does one decide? Is it based on estimates of risk-adjusted outperformance of new model over older model?
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Re: The new profitability factor, US and int'l evidence

Postby OverTheHill » Wed May 15, 2013 3:58 pm

learning_head wrote:So, as Clearly_Irrational noted, FF "explained" 98.6% of the returns. Larry indicates now there is a better set of factors that explains some "anomalies" in FF model and therefore is "better" in some sense. Question is: for investors that bought into 3-factor investment for the long term (either some time ago or just recently), should they now switch to the new factor based investments (once funds become available to them)? Would that ruin their "long-term" plan that called for potentially decades of underperformance / tracking (vs tsm) error? For younger investors, I imagine, in another 20 years there will be yet another model - would they switch at that point as well? How does one decide? Is it based on estimates of risk-adjusted outperformance of new model over older model?

First, if a person believes this [nonsense --admin LadyGeek] and follows it, then they apparently are guaranteed to profit better than anyone else on earth (even after paying fees). Second, if guaranteed isn't the right word, then something higher than 98.6% must be guaranteed. [Snarky comment removed by admin LadyGeek]
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Re: The new profitability factor, US and int'l evidence

Postby Clearly_Irrational » Wed May 15, 2013 4:13 pm

OverTheHill wrote:First, if a person believes this [nonsense --admin LadyGeek] and follows it, then they apparently are guaranteed to profit better than anyone else on earth (even after paying fees). Second, if guaranteed isn't the right word, then something higher than 98.6% must be guaranteed. [Snarky comment removed by admin LadyGeek]


I think you're over-reacting and being excessively harsh. Of course Larry is talking his book, but that doesn't mean he's wrong. Frankly I'm rather interested in the findings and I'd like to see more data and evidence. Currently it's not applicable to my portfolio in a low cost way but I'd be open to the idea of making some tweaks if it turns out the research is solid. We know that the basic FF model explains somewhere in the 90%-ish range of results, but I'd be happy to embrace a model that explains more just as I was happy to switch to FF from CAPM. I'm not going to jump on the bandwagon until I see a lot more information but classifying it as marketing hype seems a bit too dismissive.

My personal interpretation is that beta and small are risk stories while value and momentum are behavioral. Profitability still needs explaining (risk or behavioral) and I'd want some kind of confirmation that it's unlikely to be arbitraged away before I started using it. Currently I don't use momentum directly, but I feel I like I get some exposure through the use of rebalancing bands.
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Re: The new profitability factor, US and int'l evidence

Postby Jebediah » Wed May 15, 2013 4:16 pm

OverTheHill,

Wondering what do you make of this [nonsense --admin LadyGeek]?...

DFA Small Value (DFSVX), since inception (1993): Growth of 10K -> $103,681

Vanguard Total Stock (VTSMX), same period: Growth of 10K -> $55,228
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Re: The new profitability factor, US and int'l evidence

Postby umfundi » Wed May 15, 2013 4:40 pm

Jebediah wrote:OverTheHill,

Wondering what do you make of this [nonsense --admin LadyGeek]?...

DFA Small Value (DFSVX), since inception (1993): Growth of 10K -> $103,681

Vanguard Total Stock (VTSMX), same period: Growth of 10K -> $55,228

Let me make a wild guess: DFSVX is riskier than VTSMX?

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

Postby Scooter57 » Wed May 15, 2013 5:06 pm

Vanguard's small cap value fund outperforms the DFA small cap value from its inception date .

http://finance.yahoo.com/q/ta?s=VISVX&t ... a=&c=dfsvx
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Re: The new profitability factor, US and int'l evidence

Postby bottomfisher » Wed May 15, 2013 5:32 pm

Scooter57 wrote:Vanguard's small cap value fund outperforms the DFA small cap value from its inception date .

http://finance.yahoo.com/q/ta?s=VISVX&t ... a=&c=dfsvx


When I graph their performance on M* chart I get a different outcome than on dates on Yahoo chart linked. I prefer m* because it charts total return. I stopped using Yahoo charts early on when I realized it was only charting NAV (not sure if this is still true).

(Edit to erase link to M* charting performance comparison - I'm no good at that )
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Re: The new profitability factor, US and int'l evidence

Postby Scooter57 » Wed May 15, 2013 5:45 pm

Bottomfisher,

M* doesn't deduct the fee paid to the advisor you have to hire to buy the DFA fund. Compound that and you'd get an even bigger gap between VG.
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Re: The new profitability factor, US and int'l evidence

Postby LadyGeek » Wed May 15, 2013 5:59 pm

I removed some inflammatory comments. As a reminder, see: Forum Policy

We expect this forum to be a place where people can feel comfortable asking questions and where debates and discussions are conducted in civil tones... Attacks on individuals, insults, name calling, trolling, baiting or other attempts to sow dissension are not acceptable.
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Re: The new profitability factor, US and int'l evidence

Postby bottomfisher » Wed May 15, 2013 5:59 pm

Scooter57 wrote:Bottomfisher,

M* doesn't deduct the fee paid to the advisor you have to hire to buy the DFA fund. Compound that and you'd get an even bigger gap between VG.


Good point, I'm not a DFA investor (or small value tilter). But I'm just trying to give them a fair shake since the M* graph reveals substantially different findings than the Yahoo graph. DFA outperforms by quite a bit. I don't know enough about the composition of these funds to say we're comparing apples to apples even though the names are similiar and appear to indicate so.

Start date 06/16/98 (about as close as can to start of Vg Small Cap Index Inv) through present. Start $10,000 -
Vg Total Stock Market Index Inv- $21,581
DFA Small Cap Value I - $42,041
Vg Small Cap Value Index Inv - $33,666

Maybe someone smarter than me can share the graph or clarify if I'm interpretting the data correctly
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Re: The new profitability factor, US and int'l evidence

Postby Code Commit » Wed May 15, 2013 6:27 pm

Very interesting discussion, to say the least. Not sure if this is actionable in any way (at least for me, yet).

May be, Rick Ferri knew this profitability factor all along. That's why he reportedly owned BRK (if I remember correctly). VTI + VBR + BRK seems to be the low-cost secret sauce for market+small+value+profitability :wink:
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