Profitability: The Latest Dimension of Higher Expected Returns

There are three dimensions of higher expected returns in the equity markets: size, price, and profitability. Profitability is the most recent dimension to be identified by academic research, but there is significant evidence to show higher profit companies will outperform lower profit companies over time.

In this video, Envision Wealth Planning President, Bob Bolen CFA | CFP, looks at just how well high profitability stocks beat their index averages.

“I learned from when I was in college that stocks go as earnings go. That is, as earnings increase, your stock will increase. However, this is a slightly different look at profit margins,” Bob explains.

So let’s take a look at this graph.

profitability

Just to review, value stocks outperform growth stocks over time. This example from 1927-2012 value, as represented by low relative price, 11.6% per year vs. 9.25%, compared to the S&P 500 average growth of 9.82% per year.

Looking at value vs. growth in the small cap universe,  we see small cap outperforms large cap, and value outperforms growth.

Same thing happens in the international markets: value outperforming growth, and small cap index out performing the index. Same with emerging markets.

When we add the third dimension, profitability, we can look at the bottom of the chart to see these returns. We see here the top 30% of stocks in terms of profitability vs. the lowest 30%.

Fully 14.4% return on average for for high profitability beats just under 11% for low profitability in the large cap. In the small cap we see huge differences between high and low profitability. Same in international and emerging markets.

Depending on the time frame being analyzed, returns ebb and flow. What is consistent, however, is the dimension of return: higher profitability, lower value, and smaller cap stocks. We rely on Dimensional Fund Advisors because this is there core focus.

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