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.
Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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