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Rekenthaler Report

Do Profitable Companies Outperform?

Perusing finance, economics, and law.

One of the newest academic investment strategies is to seek companies that have high levels of profits. Finance professors have previously identified value, size, momentum, and liquidity factors (among others) as helping to explain stock-market returns. Now, some argue profitability--also called quality, defensive, or even "Buffettesque" factors--should be added to the list. According some academic research, buying companies that have high levels of profits leads to higher future returns. 

That seems to be basic common sense, right? Buying better companies leads to better future performance. However, investment experience teaches otherwise. Generally, buying the stocks of attractive companies, as measured by earnings or revenue growth, leads to worse returns than does buying the stocks of the dogs. Good companies are easy to own, which tends to make them overpriced. Understanding this counterintuitive finding is a key distinction between the beginning and intermediate fund investor.

Which makes this finding a head-scratcher. It's hard to believe that investors pile into fast-growth companies but are so unimpressed with high-profitability companies that the latter are underappreciated. For this, the academics have no real answer. They mutter about "risk factors" or "behavioral effects," but there's nothing risky about owning companies that are minting money and have (relatively) cheap stock prices, nor is there anything in behavioral research that seems to fit the explanation.

On the other hand, who am I to contradict Morningstar's equity researchers? They've been carrying on about economic moats for 15 years now--a moat being a competitive advantage that permits a company to enjoy high profit margins on an ongoing basis. In other words, profitability. Morningstar's definition of moat differs from the concept of profitability used in academic research, but clearly there's overlap between the two. And in its short history, a public fund that trades in Morningstar's moat strategy--ELEMENTS Morningstar Wide Moat Focus ETN --has fared pretty well.

So, I am torn. I don't understand the logic for this strategy. It's easy to see how money can be made buying loathsome firms that others detest, or by providing liquidity to a market by buying thinly traded stocks. I can't for the life of me understand why buying high-profit companies would work. But the numbers have been there. Let's call it a draw for now, and keep watching.

By the Book
For $5,876, you can take a 10-week course at the University of Chicago Booth School of Business that will teach how consumers make rational economic decisions. If you charge the same price for an item, but vary the terms--for example, change from an up-front payment to 24 monthly installments with the interest costs built in--you won't fool the public, which will understand that the economic cost remains unchanged even if the details are different. Or you can live in this world and see just how wrong that precept can be.

At a recent round table of law professors and lawyers who specialize in mutual fund issues, one attendee proposed that mutual funds no longer be permitted to collect their expenses by taking money out of a fund, but instead should send shareholders an annual bill that they would need to pay directly (via check, credit card, and so on). This would increase investor awareness of fees, he said. The proposal was nixed by other attendees because then "nobody would buy mutual funds."

This makes no sense whatsoever, per the Booth School. And it's correct.

Sue Me
Another discussion topic at the round table was the 2011 Supreme Court decision Janus Capital Group Inc. vs. First Derivative Traders, which ruled that Janus was not liable for misleading statements made in a prospectus of one of its funds. The court stated that the fund itself rather than the fund company issued the prospectus, so therefore only the fund could be sued. The fund company was immune. The court's analogy was that a speaker (the fund itself) is responsible for what is said, not a speechwriter (the fund company).

This never made sense to me. First, from a practical perspective, restricting shareholders to suing the fund means that shareholders have no real legal recourse for a fraudulent prospectus. In suing the fund they sue themselves; there's no money to be recouped from that action. Second, the analogy is clearly wrong. Speechwriters work for speakers, but fund companies don't work for funds. That holds particularly true with prospectuses, which are technical documents written by employees who work at the fund company. The board does not create prospectuses, any more than it runs the investment operations.

Somewhat to my surprise (I don't expect my gut reaction to a Supreme Court ruling to be correct), the group unanimously shared my viewpoint, and the subject was dispensed with quickly, accompanied by wry smiles.

What's in a Word?
Per Miriam-Webster, to peruse an item means either to look at it closely and in detail, or to treat in a cursory fashion. It's always nice when a word can mean whatever you want! My use of the word in today's subheadline means the latter, of course.

Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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