Factor Investing: The Profitability Factor
This post will introduce Invariant’s large cap U.S. single stock strategy – Profitability Alpha. Profitability Alpha is a rules-based, systematic strategy – commonly known as factor investing. Before we talk further about Profitability Alpha, we need to define and understand what factor investing is.
What is “factor investing”?
From Vanguard, “Equity factor-based investing is a form of active management that aims to achieve specific risk or return objectives through systematic, rules-based strategies. It can be used in a number of applications — for example, static tilts, active fund substitution, and portfolio completion. This paper explores these potential portfolio roles using hypothetical case studies.”
The most popular factors today are:
· Size – attempts to capture excess returns of smaller firms relative to their larger peers.
· Value – attempts to capture excess returns of stocks that have low multiples.
· Momentum – attempts to capture excess returns of stocks with stronger recent performance.
· Carry – attempts to capture excess returns of stocks that have higher-than-average dividend yields.
· Quality – attempts to capture excess returns of stocks that have low debt, stable earnings growth, and high return on equity/assets.
While these descriptions represent the overarching themes of popular factors today, the “devil is in the details” and implementations can make all the difference. For example, a naïve value factor can be sorting companies based on P/E, P/B, EV/EBITDA, etc. Other rules, such as excluding stocks with high short interest, can be implemented to screen out undesirable names. A strategy can have constraints on sector exposure, or even conduct the screening/ranking within sectors so unintended sector bets are not made. Additionally, rebalancing frequency and rules can result in different returns within the same “factor.”
Profitability Factor Academic Research
The most well-known Profitability Factor paper was written in June 2012 by Robert Novy-Marx called “The Other Side of Value: The Gross Profitability Premium”, states that firm profitability (measured by gross profits to assets) has roughly the same predictive power when it comes to cross-sectional stock returns as book-to-market. His paper expands on Fama and French (2006), which showed that firms with high profitability measured by earnings have higher forward-looking returns. Asness, Frazzini, and Pedersen (2014) investigate the returns of what they refer to as higher quality stocks, resulting in a similar conclusion despite a slightly different methodology.
Novy-Marx begins his paper by suggesting that the profitability premium is similar in intuition the value premium. He states, “While traditional value strategies finance the acquisition of inexpensive assets by selling expensive assets, profitability strategies exploit a different dimension of value, financing the acquisition of productive assets by selling unproductive assets” (Novy-Marx, pg. 1). When viewed in this context, along with the fact that profitable firms tend to have a higher book-to-market than unprofitable firms, profitability can be thought of as “the value of growth.”
The final sentence summarizes the factor well – it seeks to find profitable growth companies that are undervalued relative to their fundamentals.
1) Identify Universe
Since we are initially only considering large cap U.S. equities for the screen, we begin with S&P 500.
2) Screen for Profitability
We screen for profitable firms by looking for high EBITDA relative to total capital while having low reinvestment needs.
EBITDA is a metric that is widely used by investment bankers and often criticized by the likes of Warren Buffett, as it can ignore the reinvestment required to maintain or grow profits by excluding depreciation expense. By subtracting capital expenditures from EBITDA, we attempt to adjust for this required reinvestment and get a better measure of true returns on capital for stakeholders in the firm.
3) Screen for Earnings Growth
We screen for non-negative earnings growth as we do not want to own firms with declining earnings.
4) Remove High Short Interest
The final part of the screening process is to remove firms that have short interest greater than 10% of the available float. Typically, short sellers are sophisticated market participants and if short interest in a single stock is disproportionately high, we do not want to own it.
Once the screening is complete, we then rank the screened list using value, quality, and institutional accumulation metrics. The top 20 ranking names are invested in, and the portfolio is re-constituted twice annually. To reduce turnover, current holding are only sold if they do not meet the screening criteria or if they fall below a specific ranking threshold.
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