Article regarding DFA's addition of Profitability screen

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matjen
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Article regarding DFA's addition of Profitability screen

Post by matjen » Thu Aug 08, 2013 12:30 pm

Here is a brief article consistent with some of the research/news that Larry Swedroe has presented in the past few months. DFA is adding this factor.

Sweeping changes under way at DFA
"Thanks to a breakthrough in asset-pricing research last year, DFA is adding a third layer of screening to its equity portfolios, which already tilt toward small and value stocks. The new layer, or dimension, focuses on a company's persistence of profitability — basically a stock's ability to earn a profit consistently."

http://www.investmentnews.com/article/2 ... /130809943
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Re: Article regarding DFA's addition of Profitability screen

Post by LAlearning » Thu Aug 08, 2013 12:52 pm

"The breakthrough came late last year when DFA began looking at companies' earnings-to-assets and earnings-to-book, rather than cash flow or earnings-to-price."
--Cause no one in the history of the stock exchange has ever done this.

"When DFA looked at the back-tested results of overweighting the most profitable companies in its portfolios, the results weren't inconsequential, Mr. Repetto said."
--I too wish my portfolio was based on back-tested results and was invested at the exact moment in time to produce 10000% return. However, we live in the now, without even a glimpse into the future.

And don't forget, you have to pay an advisor to use these 'breakthrough' funds. I think I'll keep paying myself and go play some racquetball....
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Re: Article regarding DFA's addition of Profitability screen

Post by matjen » Thu Aug 08, 2013 2:44 pm

LAlearning wrote:And don't forget, you have to pay an adviser to use these 'breakthrough' funds. I think I'll keep paying myself and go play some racquetball....
Well, other than some 529 plans it is true that you do have to pay to get access to DFA funds. However, that fee can be as little as $1,000/yr per household. If someone needs/desires a qualified adviser then I suppose you are in the 35 to 100 basis point range depending on adviser and AUM. There are ways to pay much less than that and, I assume, receive less adviser guidance. To each his or her own.
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Re: Article regarding DFA's addition of Profitability screen

Post by caklim00 » Thu Aug 08, 2013 2:50 pm

Interesting, is this similar to a fundamental approach (IE. RAFI and Russell Fundamental)?

Does this mean even their non-Value tilted funds will assume more or a Value tilt? I ask as I have access to DFISX (International Small) in a prior company 401k, but I've been using SFILX in my IRA to get the Value tilt.

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Re: Article regarding DFA's addition of Profitability screen

Post by technovelist » Thu Aug 08, 2013 2:52 pm

Groundbreaking research!
Wait, aren't they one of the "passive beats active" advisory groups?
I guess if you can pick winners by backtesting, then active is better?
Now I'm so confused! :oops:
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Re: Article regarding DFA's addition of Profitability screen

Post by larryswedroe » Thu Aug 08, 2013 3:39 pm

Actually they will be a bit less valuey because profitability stocks are more growthy stocks. But the correlations are low/negative so you reduce volatility of portfolio a bit, gain another premium, and also reduce that dread disease known as tracking error risk (you look more market like) and also the TSTAT of the premiums jumps--so the expected premium of the portfolio is now higher

The way it is being implemented has expected returns rising about 40-70bp depending on the portfolio.
Again with increased reliability of the premium, lower SD and lower TE.
Larry

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Re: Article regarding DFA's addition of Profitability screen

Post by VennData » Thu Aug 08, 2013 6:16 pm

LOL, they will use a company's past profitability to predict future profitability... and you will need a fee-based adviser to get access.

Hardee haha. They'll have the suckers lining up for this one. Enjoy those fees flying out the window.

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Re: Article regarding DFA's addition of Profitability screen

Post by larryswedroe » Thu Aug 08, 2013 7:44 pm

VEnnDATA
Well you might be interested to know that this is the very insight that brought Novy-Marx's paper to be so highlighted. By moving up the income statement to gross profitability he found that yes past profitability predicts future profitability--in other words profitability persists and does so for a long time. If memory serves like 7 years.

NOte that AQR, which has some of the smartest people in finance has also incorporated profitability into their funds, and I would bet others will follow.

Perhaps you might think differently if you also knew that AQR found that this was the "secret sauce" behind Buffett's alpha---So I guess Buffett is a sucker--once you accounted for profitability and the leverage from BRK's insurance operations there was no significant alpha any longer. In other words Buffett had no stock picking skills, he just figured out the profitability factor 50 years or so before the academics did. You could replicate his performance (ex the leverage) by simply buying an index of these type of stocks.

Larry

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Re: Article regarding DFA's addition of Profitability screen

Post by Ranger » Thu Aug 08, 2013 8:19 pm

What i don't understand is that Benjamin Graham taught and used gross profitability extensively. Why such a basic factor is a recent phenomenon is puzzling to me.

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Re: Article regarding DFA's addition of Profitability screen

Post by alec » Thu Aug 08, 2013 9:08 pm

Ranger wrote:What i don't understand is that Benjamin Graham taught and used gross profitability extensively. Why such a basic factor is a recent phenomenon is puzzling to me.
And buffet was a disciple of Graham. :oops:
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Re: Article regarding DFA's addition of Profitability screen

Post by stlutz » Thu Aug 08, 2013 9:20 pm

What i don't understand is that Benjamin Graham taught and used gross profitability extensively. Why such a basic factor is a recent phenomenon is puzzling to me.
It's not a recent phenomenon. It only is in the world of DFA.

I remember a year ago on this board when some of the various experts would insist that it's not really possible to improve upon the Fama-French 3 factor model (or possibly the 4 factor model). Then, all of a sudden, this group got comfortable with the type of factor investing that quant funds have been doing for many years.

Personally I think this is a positive development as it moves us away from the semi-religious "my factor is better than your factor" type of stuff that used to go on.

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Re: Article regarding DFA's addition of Profitability screen

Post by Kenkat » Thu Aug 08, 2013 9:22 pm

And the lines between active management and passive management get even more blurry...

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Re: Article regarding DFA's addition of Profitability screen

Post by wjo » Thu Aug 08, 2013 11:36 pm

My concern about the profitability factor is that I would think it is too easy to screen for - if DFA, AQR and everybody else starts using it, won't that bid up the price of the "profitable" stocks?

For value funds, the argument for DFA is that they hold a lot of stocks, are patient traders, avoid market impact, make money securities lending, etc. Thus they are able to capture the risk premium/FF3 factor exposure pretty well. Other value stock vendors are also able to do that to various extents, but the universe of value stocks is relatively large. (Also, if a stock gets bid up, its value factor goes down and it is easy for a value oriented fund to sell it and take the profit or just not buy the stock to begin with.)

With profitability as a factor, the universe of stocks with high/sustained profitability is by definition much smaller - if large numbers of fund families are chasing those stocks, its not at all clear to me that any profitability premium will be sustained - the stock price will just be bid up. (Backtesting doesn't account for this.) Value makes a pretty good argument to me about risk and behavior, and is distributed over a broad sector of the market. The profitability factor seems a little too limited to me, and a lot like momentum - something that back tests really well but does not have much of a risk story to back up a premium over market return.

Now, the folks at DFA and AQR are smart people and I doubt I'm the first to have the concerns outlined above - but I would like to hear a convincing argument about why the premium is sustainable now that we know how to look for it.

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Re: Article regarding DFA's addition of Profitability screen

Post by exeunt » Fri Aug 09, 2013 3:13 am

wjo, actually the universe of profitable companies in terms of aggregate market cap is probably bigger.

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Re: Article regarding DFA's addition of Profitability screen

Post by Methedras » Fri Aug 09, 2013 3:56 am

Now, this is only a hunch, but my gut tells me that the "gross profitability premium" is not a risk story. I can't really imagine how it coule be, altough I am not claiming to be 100% certain about this.

If I am correct, it would simply be that not many investors/funds are screening for this factor, and as Larry stated eariler in this thread, by screening DFA expects to yield perhaps 40-70 additional basis points while reducing standard deviation slightly. But, if this is at all reliable and unrelated to increased risk, I expect computer trading to arbitrage this advantage away very soon.

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Re: Article regarding DFA's addition of Profitability screen

Post by larryswedroe » Fri Aug 09, 2013 7:41 am

Few quick comments
There is some risk story here, but not perhaps as clear as in other cases
Highly profitable companies do show persistence. So you can screen for them. Moving up the income statement was the key because when using lower down figures like net income that isn't there.
Then these companies are growth type companies, meaning more of their value is further out, making it more risky than companies whose values are based on earnings closer in time. Then you can also clearly argue that high profitability attracts more competition (competition doesn't enter where there is low profitability). That makes it more risky. Those are the risk "stories"

Having said that, and it's nice to have the risk story but there is no risk story on MOM, and many think Value is mostly if not all a behavioral story as well and yet for variety of reasons they persist despite decades now of everyone knowing about them.

Also you don't even need to buy the highly profitable ones to add value, just as DFA has added value by screening out the extreme small growth stocks you can add value by also screening out the low profitability stocks--and btw screening out the high volatility stocks which also have god awful returns

BTW-if you think it will now be arbed away over time you should jump on it now as the prices will then get pushed up and you get the one time K gain.

I would add that while I am also somewhat skeptical here, I don't see the downside risk as you only give up a small amount of value tilt to get this and you do reduce TE, and as I said simply by avoiding the lowest profitability stocks you are likely to add value.

For what it's worth Novy Marx paper has generated more excitement in the finance world than any other since FF's groundbreaking paper. This has nothing to do with DFA, the whole finance world is excited about this.

Hope that helps
Larry

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Re: Article regarding DFA's addition of Profitability screen

Post by wjo » Fri Aug 09, 2013 11:04 am

It seems that the predictions and explanations around the value add for profitability is like trying to have it both ways. You can't add the value DFA is talking about without some significant reconstitution of the portfolio - either in terms of holdings or buy/sell points. So you can't say there is little downside risk.

Less tracking error, less volatility, and 40-70bp increase! If someone else came on this board and said I have a risk fee way for you to add 0.5% to your portfolio every year they would likely be dismissed out of hand. Everything I know about basic truths in investing is there is no free lunch - the profitability story seems to contradict this tenet.

I own quite a bit of DFA funds so I may get a one time bump. I can see to an extent how the DFA core funds could benefit a bit from this type of screening, but it is unclear that it is a free lunch.

My larger question is to what extent the standard DFA value funds will start to include profitability in their portfolio constitution. If they do, I may be tempted to go back to Vanguard funds - especially now they are using the CRSP indexes they should be a little deeper/purer value than before.

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Re: Article regarding DFA's addition of Profitability screen

Post by wjo » Fri Aug 09, 2013 11:22 am

exeunt wrote:wjo, actually the universe of profitable companies in terms of aggregate market cap is probably bigger.
Do you have data on this?

If you are starting with a value oriented fund, by definition, only a subset will make the profitability screen.

If you are starting with the universe of stocks and screen for profitability, you will reduce the set considerably - and then you must decide how to add back in value. In any case, you will start with a portfolio that is overweight in a select number of stocks. One of the things I have really liked about DFA value funds is that they have made an attempt to own a lot of stocks compared to other value funds. Sure, that means they have some losers but it also means they limit concentrated bets. Time has shown DFA funds do a pretty good job of capturing the FF size and value factors and they have a long track record.

I am all for thoughtful improvement, but profitability strikes me as a really good academic study with limited practical value -- now that everyone knows about it, will it persist? Value has shown to persist, but there is some thinking the premium has been reduced (read Bill Berstein's recent musings). Momentum had a run with AQR, but the recent data I remember shows the momentum funds not doing as well of late.

If a factor is too easy to capture, it is not clear to me that it can't be arbitraged pretty quickly. Value is not super easy to capture and we know it has periods of underperformance, so not everyone will chase it. Profitability seems a little too easy by comparison.

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Re: Article regarding DFA's addition of Profitability screen

Post by larryswedroe » Fri Aug 09, 2013 11:47 am

wjo
Answer is value and profitability premiums are similar but different, low/negative correlation--hence the lower portfolio SD while adding to returns.
Also easy to do in same way DFA screens out extreme small growth from small cap portfolios, now screen out extreme low profitability value stocks,even if valuey
Hope that helps
Larry

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Re: Article regarding DFA's addition of Profitability screen

Post by nedsaid » Fri Aug 09, 2013 9:55 pm

When I was a client of a major brokerage firm, I remember the firm's research report that talked about "ruler" stocks. These were firms that grew earnings at predictable rates such as GE and Coke. The idea was that you could use a ruler on a graph and trace the growth of earnings.

What happened was that the CEO's of GE and Coke managed earnings. GE would time asset sales to give the appearance of earnings growth. Supposedly, the "ruler" stocks grew earnings at 15% a year. Pure baloney. The underlying growth rate was more like 8% if that. I used to joke that Coke spun off everything but their logo. I suspected that CEO's like Jack Welch managed earnings and the stock price and not so much the underlying businesses.

The performance factors that Larry Swedroe talks about have been known for some time. The academics now have numbers to back them up. The brokerage houses have talked about a lot of these things for a long time though their execution has been questionable. I do remember stocks being rated for momentum for example. They have talked about "quality" stocks for a long time. Unfortunately, the stocks with persistent earnings tend to have higher P/E's.

The concern I have about chasing these performance factors (small, value, profitability, liquidity, momentum) is that this leads to active management under a different name. The active managers use computer screens also, it appears now that the difference between them and DFA are the fees. If there are low fees, it is called investing for performance premiums. If the fees are higher, it is called active management. We seem to be getting further and further away from indexing.

Are we really talking about anything new here?
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Re: Article regarding DFA's addition of Profitability screen

Post by stlutz » Fri Aug 09, 2013 11:48 pm

There is some risk story here, but not perhaps as clear as in other cases
Highly profitable companies do show persistence. So you can screen for them. Moving up the income statement was the key because when using lower down figures like net income that isn't there.
Then these companies are growth type companies, meaning more of their value is further out, making it more risky than companies whose values are based on earnings closer in time. Then you can also clearly argue that high profitability attracts more competition (competition doesn't enter where there is low profitability). That makes it more risky. Those are the risk "stories"
Isn't it really the case that these companies are less risky? If you were buying a business from someone, would you think you were taking more of a chance buying one that turns a steady profit vs. one that does not? I sure wouldn't.

For that matter, the same is arguably true about value. Is it riskier to pay $10 for a $1 of earnings or $20 (all other things being equal)?

Finally on momentum: Is it riskier to follow the crowd or to make a contrarian bet?

Perhaps it's time for to conclude that investors are willing to pay up for riskier stocks and the higher potential returns that such investments offer. The trade-off for those higher potential returns is that you get a lower level of "most likely" returns.

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Re: Article regarding DFA's addition of Profitability screen

Post by Robert T » Sat Aug 10, 2013 2:54 am

.
It will be interesting to see how the new DFA screens on profitiability show-up in returns. Here’s a list of funds that also have a significant ‘profitability’ load in descending order of magnitude (among those I have looked at).

Powershares RAFI Fundamental Pure Small Value*
Bridgeway Ultra-small Company Market
Powershares RAFI US 1500*
iShares S&P600 value*

*based on the underlying index

The RAFI ‘profit’ sort (as Arnott calls it), the Bridgeway's screens to avoid companies passing through the bankruptcy, and the S&P financial viability sort all seem to capture some of the profitability premium (using the Novy-Marx ‘profitability factor" data). The statistical significance of this factor is largest in the RAFI funds.

This extract from the linked article on DFA in the OP is sounding 'RAFIish'– “The company found that using a stock's price doesn't lead to any reliable data, because the price of a stock can be very volatile. Using a company's assets or book value, by contrast, provides a more reliable look at how profitable a company is and how likely it is to continue to be profitable.”

Robert
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Re: Article regarding DFA's addition of Profitability screen

Post by IlliniDave » Sat Aug 10, 2013 5:34 am

All this stuff is pretty interesting, but I'm too much of a cheapskate to pay the price of admission to DFA. I admit I haven't looked into the details of this "new discovery", but it seems we've sort of come full circle.

I think I'll start keeping a running list of all the new revelations that have come along in my investing lifetime. The biggies so far are:

1. Lower price multiples are generally better for investors
2. Companies that are profitable are generally better for investors
3. Smaller companies are better for investors
4. Companies that have been good for investors are likely to be good for investors

Number 3 is the only one that wouldn't be kind of a well, duh, sort of thing from a complete layman's perspective. I salute the guys/gals in the academic world that have established the mathematical backing, but buying stocks of consistently profitable companies when they're trading at favorable prices relative to "the competition" seems more like salt-and-pepper than some kind of magic sauce. Hopefully some other providers out there will find a way to capture some of those things for little guy investors for reasonable fees now that the metrics have been fleshed out.
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Re: Article regarding DFA's addition of Profitability screen

Post by larryswedroe » Sat Aug 10, 2013 7:11 am

Robert
An important point is that DFA previously only screened value by BtM. If you screen by other metrics such as P/CF you are getting a profitability screen. So Bridgeway and RAFI were to some degree picking that up because of their use of multi value screens instead of one
Larry

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Re: Article regarding DFA's addition of Profitability screen

Post by abuss368 » Sat Aug 10, 2013 9:25 am

Interesting. I do however find Jack Bogle, Rick Ferri, and David Swensen's arguments and research related to market capitalization indexing way too convincing!
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Re: Article regarding DFA's addition of Profitability screen

Post by KarlJ » Sat Aug 10, 2013 12:19 pm

Robert T wrote:.
It will be interesting to see how the new DFA screens on profitiability show-up in returns. Here’s a list of funds that also have a significant ‘profitability’ load in descending order of magnitude (among those I have looked at).

Powershares RAFI Fundamental Pure Small Value*
Bridgeway Ultra-small Company Market
Powershares RAFI US 1500*
iShares S&P600 value*

*based on the underlying index

The RAFI ‘profit’ sort (as Arnott calls it), the Bridgeway's screens to avoid companies passing through the bankruptcy, and the S&P financial viability sort all seem to capture some of the profitability premium (using the Novy-Marx ‘profitability factor" data). The statistical significance of this factor is largest in the RAFI funds.

This extract from the linked article on DFA in the OP is sounding 'RAFIish'– “The company found that using a stock's price doesn't lead to any reliable data, because the price of a stock can be very volatile. Using a company's assets or book value, by contrast, provides a more reliable look at how profitable a company is and how likely it is to continue to be profitable.”

Robert
.
I was wondering about the profitabity loads for some other ETFs and how one would determine this. I found the following on a Bogleheads search:
I was interested in finding out the factor loading of this new ETF. I grabbed the simulated index data from the S&P website and created monthly return data by taking the index value at the last trading day of each month. The first monthly return is Nov. 2007. I did the FF regression and got:

alpha: -0.08 (monthly)
Market: 0.97
SmB: -0.09
HmL: 0.25
R2: 0.99


I'm kind of disappointed the value loading isn't greater say 0.5-0.6 since that would be useful in creating portfolios with higher value loading yet with a diversified portfolio. We'll have to see how it behaves in real life.

Data Source: http://us.spindices.com/indices/strateg ... tilt-index
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Is this similar to what needs to be done to find out the profitability load, or is there a place to simply look it up?

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Re: Article regarding DFA's addition of Profitability screen

Post by momar » Sat Aug 10, 2013 12:27 pm

Once again, if it took this long for all these geniuses to look at profitability when backtesting, they ought to be embarrassed. As a corollary, I don't know how anyone can trust what they say since they are so certain about everything, even when they are changing their tunes year to year.
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Re: Article regarding DFA's addition of Profitability screen

Post by Beagler » Sat Aug 10, 2013 12:49 pm

alec wrote:
Ranger wrote:What i don't understand is that Benjamin Graham taught and used gross profitability extensively. Why such a basic factor is a recent phenomenon is puzzling to me.
And buffet was a disciple of Graham. :oops:
Was? Has he passed away?
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Re: Article regarding DFA's addition of Profitability screen

Post by Beagler » Sat Aug 10, 2013 12:52 pm

matjen wrote:Here is a brief article consistent with some of the research/news that Larry Swedroe has presented in the past few months. DFA is adding this factor.

Sweeping changes under way at DFA
"Thanks to a breakthrough in asset-pricing research last year, DFA is adding a third layer of screening to its equity portfolios, which already tilt toward small and value stocks. The new layer, or dimension, focuses on a company's persistence of profitability — basically a stock's ability to earn a profit consistently."

http://www.investmentnews.com/article/2 ... /130809943
It should not surprise investors that cap-weighting might not be the be-all, end-all of investing. Are there other rational options other than cap-weighting? You beta believe it. :D
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