Is it possible for investors to buy cheap, profitable companies (have their cake) and earn higher expected returns (eat it too)? Research shows – yes, with some caveats.
In our book, Your complete guide to factor-based investing, Andrew Berkin and I identified just five equity factors from the zoological factor that met all the criteria we set for investing, a premium that was: stable across time and economic regimes, spread across industries, countries, regions and asset classes; consistent with different definitions; bear transaction costs; and there are intuitive risk-based or behavioral explanations for why the premium should continue to persist. Two of the five were value and profitability (along with the related quality factor, a broader measure than just profitability as it also includes low earnings volatility, low financial leverage, high asset turnover, low operating leverage and risk low individual shares).
In our study, “Combining Value and Benefit Factors to Improve Performance,” published in Journal of Beta Investment Strategies, Andrew Berkin and I showed that portfolios formed at the intersection of stocks with both high value and profitability characteristics outperformed portfolios with moderate characteristics, which in turn outperformed portfolios of stocks with low characteristics. These results were consistent, widespread, robust, investable and intuitive, giving us greater confidence in their continued efficacy. We also showed that in contrast to the traditional book-to-market value measurement, value measures using earnings and cash flow provide significant exposure to profitability and thus act as a useful complement. Our findings were consistent with those of Sunil Wahal and Eduardo Repetto, authors of the June 2020 study “On the shared nature of value and benefit” (summary here).
The latest research
Chris Satterthwaite and Lionel Smoler-Schatz of Verdad contribute to the factor investing literature in their research report “The combination of value and quality,” in which they examine the relationship between value and quality in US stocks. Their quality metric is earnings/gross assets, taken from Robert Novy-Marx's 2010 paper The Other Side of Value: Good Growth and the Gross Profitability Premium. Their data sample covers period 1990-2024.
They began by asking, “Would you rather own a portfolio of cheap, low-quality companies or a portfolio of expensive, high-quality companies?” To answer this question, they evaluated the equity universe on their value factor (EV/sales, EV/EBITDA, P/E, P/B) and their quality factor (GP/assets). They then looked at the correlation between value and quality scores, dividing the universe into large and small caps (defined as having a market cap < $1 billion) for both US and international stocks. At least in the large stocks, their findings were as you might logically expect: there was a negative correlation between quality and value—on average, higher quality (more profitable) companies were more expensive. However, this was not true in small caps, where the relationship was positive—higher quality (more profitable) companies were actually cheaper—a behavioral anomaly (explained by retail investor preference for lottery-like actions).
To test the robustness of their findings, Satterthwaite and Smoler-Schatz also examined quality as measured by a composite of ROE, ROA, ROIC, and EBITDA margin and saw the same trends emerge.
They then looked at how buying small, cheap and profitable companies has improved returns.
As you can see in the charts above, the most profitable firms delivered higher returns in both small-cap and large-cap stocks. However, the returns of high-earning free companies were much greater in small-caps (12.6% vs. 9.6% in large-caps on a market-cap-weighted basis and 21.0% vs. 8.6% on an equal-weighted basis ). The reason is that large, expensive, high-return stocks had almost the same return as cheap, high-return, large-cap stocks, while small, cheap, high-return stocks had much higher returns. higher than expensive, high-yielding, small-cap stocks.
The combination of factors does not work with value and profitability alone. In their 2013 study “A new paradigm of core capital,” Andrea Frazzini, Tobias Moskowitz, and Robert Novy-Marx showed that the combination of value, profitability, and momentum not only produced more efficient, diversified, long-only portfolios, but also that these factors go a long way toward explaining why some portfolio managers excel—they have greater exposure to these factors by using efficient construction rules to minimize the negative impact of trading costs.
Further support for multi-factor portfolios
In his April 2022 letter, “Combination of Factors,” Christoph Reschenhofer investigated the performance of multi-factor portfolios and found that factor premiums were all larger in small stocks than in large stocks and when comparing single characteristic portfolios with multivariate characteristic portfolios (where the overall score was calculated as the equal weighted average of the individual scores) , averaging multiple firm characteristic scores produced portfolios with more favorable risk-return characteristics (lower volatility and higher post-cost returns) than the market and those of portfolios ranked by biased characteristics. The small-cap (large-cap) portfolio exhibited a 70 percent (25 percent) increase in the post-transaction cost Sharpe ratio compared to the market portfolio.
Investor Relations
The empirical evidence we reviewed provides support for multiple characteristic-based valuations to form long-only factor portfolios, encouraging the combination of slow-moving characteristics (such as value, investment, and/or profitability) conditional on fast-moving features (such as momentum) to reduce wallet turnover and transaction costs. Fund families, such as AQR, Avantis, Bridgeway and Dimensional, use such an approach, integrating multiple features into their portfolios conditional on momentum signals. The research also shows the important role that portfolio construction rules (such as creating efficient buy and hold ranges or imposing screens that exclude stocks with negative momentum) play in determining not only the risk and expected return of a portfolio, but also how efficient the strategy can be. be implemented (taking into account the impact of turnover and trading costs) – wide (narrow) thresholds reduce (increase) portfolio turnover and transaction costs, thereby increasing returns after costs and Sharpe ratios. (Note that there is a trade-off in that wider bands reduce exposure to desired characteristics—so returns may decrease both before and after costs if the bands are too wide.)
Larry Swedroe is the author or co-author of 18 books on investing, including his latest, Enrich your future: the keys to a successful investment.