While the link between profits and stock returns should be clear, historically investors have not fully appreciated the long-term persistence of profits.
It's surprising that value stocks have done as well as they have. Value stocks tend to be less profitable than their growth counterparts, and yet they have historically traded at steep enough discounts to outperform growth stocks in nearly every market studied over long horizons. But price is only one aspect of value. Controlling for risk, a company's future profitability drives its intrinsic value. While companies that consistently generate high profits command higher valuations than traditional value stocks, the market has also historically undervalued these companies. This anomaly is consistent with Warren Buffett and Charlie Munger's philosophy that it is better to buy a great company at a fair price than a fair company at a great price.
Profitability measures how productively a company uses its investors' capital and assets. Simply comparing net income or earnings per share across companies does not adequately capture this idea. It is often possible for a company to boost its net income by acquiring more assets, but that does not necessary improve its productivity--just the opposite. The marginal returns to capital tend to diminish with size. In other words, investors often get less "bang for the buck" for each additional dollar invested in the business. In order to control for differences in invested capital and assets, researchers define profitability using metrics, such as return on invested capital, gross profits/assets, and adjusted operating income/book value of equity.
While equity analysts spend a lot of time projecting future cash flows and profits, several recent studies have found that one of the best estimates of a firm's future profitability is its current profitability. For instance, Dimensional Fund Advisors found that profits in one year could explain profits up to seven years in the future, using U.S. stock data from 1975-2012 (Dimensional Quarterly Institutional Review, first quarter 2013). This may be because the most profitable companies tend to be those with sustainable competitive advantages. The following table illustrates the average return on invested capital from 2010-12 for all U.S. stocks Morningstar covers with a market cap of at least $1 billion, grouped by economic moat rating. This rating reflects Morningstar's assessment of the durability of company's competitive advantage. Over this period, companies with the strongest competitive advantages (wide economic moats) generated the highest returns on invested capital.
Directionally, the market prices this information correctly. Highly profitable firms tend to command higher valuations than their less profitable counterparts. However, controlling for value, they have also historically offered better returns, which suggests that investors have not fully appreciated the persistence of profitability. Defining profitability as adjusted operating income/book value of equity, DFA found that the stocks of highly profitable firms in the U.S. outperformed the least profitable firms by more than 5% annualized from 1975-2012, with lower volatility. It also uncovered this relationship in foreign developed markets (1991-2012) and emerging markets (1995-2012), where the profitability performance gap was about 5% and 6%, respectively. Robert Novy-Marx published similar results in his paper, "The Other Side of Value: The Gross Profitability Premium," which defined profitability as gross profits/assets. He found that the most profitable U.S. firms outperformed their counterparts on the other side of the spectrum by about 3.8% annually, from 1963-2010.
Value and Profitability
While the profitability premium appears to be robust when controlling for value, the evidence is mixed when this control is removed. In a paper published in 2007, “The Profitability Premium in Equity Returns,” David Brown and Bradford Rowe found that the profitability premium went away without this control. This is because an unconstrained portfolio that targets profitable firms overweights growth stocks, which have historically underperformed value. However, they illustrated that the profitability premium is present across the value-growth spectrum. Consequently, both value and growth managers could improve their performance by tilting toward profitable firms. Similarly, Novy-Marx found that the benefit from targeting profitable firms becomes stronger when combined with value.
Efficient-market advocates have long argued that the value premium is compensation for risk. It is difficult to articulate a risk based explanation for the profitability premium that is consistent with this view. Where value stocks often represent distressed companies with dim growth prospects and poor recent performance, highly profitable firms tend to be high quality with durable competitive advantages. According to DFA's analysis, these stocks have also historically been less volatile. Does risk really increase with profitability? Not likely.
Yet, it is also difficult to identify a consistent behavioral explanation for both the value and profitability premiums. According to this school of thought, value stocks outperform because investors tend to extrapolate past growth too far into the future, pushing prices away from their fair values. But then why wouldn't investors make the same mistake with profitability? One possible explanation is that profitability doesn't inspire as much excitement as growth. Profitable companies, such as Johnson & Johnson JNJ, McDonald's MCD, and Microsoft MSFT, tend to be boring, mature, and high quality. It is easier to get excited about companies, such as Salesforce.com CRM and Netflix NFLX, that offer disruptive technology and the possibility of large payoffs.