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Time to Add Profitability to Portfolios: Eric Nelson

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Compound interest, the availability of credit, the return and risk benefits of diversification—these are some of the underappreciated wonders of the world (to paraphrase Einstein’s assessment of compounding) that aid financial advisors in doing their jobs.

Here’s another—which is a subdivision of diversification—that you might not have heard too much about: profitability.

Fama-French factor analysis fans who took finance classes sometime around 1992, or hopefully kept up with evolving financial theory, understand that this model explains that beta, small and value factors enhance portfolio returns.

The two finance professors updated their model a year ago to include five factors, one of which is profitability (the fifth is called investment).

In a new post, advisor and finance thought leader and blogger Eric Nelson of Servo Wealth Management takes a close-up look at the effect of this fourth factor on investment returns and finds that profitability seems to, well, enhance portfolio profits considerably.

The funds of Dimensional Fund Advisors—Eugene Fama and Kenneth French are DFA directors and consultants—began including profitability in buy and sell decisions last year, incorporating the latest Fama-French theoretical findings in their portfolio construction.

But Nelson, a committed DFA advisor, looked at simulated results for U.S. stocks over the period 1975 to 2011, finding the profitability effect to be especially pronounced in growth stocks.

Respective returns for growth stocks, both large and small, rose by 2.9% and a whopping 5.7% percent annually. (So, for example, small growth index returns of 9.5% per year over the period would have been 15.2% annually had the index included profitability as a factor in its buy-sell decisions.)

What’s more, inclusion of profitability had a similarly huge impact on portfolio risk among growth stocks, with volatility dropping 6.7% (from 24.7 to 18%) for large growth and 6.6% (from 28.4 to 21.8%) for small growth.

Nelson found smaller-magnitude benefits for value stocks and for “market” (a blend of value and growth) stocks.

The former saw a 0.9% and 1% boost for large and small stocks, though large value risk went up a negligible 0.1% while small-value risk fell by a meaningful 2.1%.

“Market” naturally also benefited from profitability, with portfolio gains of 1% and 1.9% for large and small stocks, and a reduction of risk by 0.2 and 1.3% respectively.

The Oklahoma City-based wealth manager cautions that all these results are based on back-testing, and we cannot know if they will be repeated in the future, and further that it is not completely clear as yet that profitability is the sole determinant of these results—something future regression analyses might reveal.

But Nelson tells ThinkAdvisor that future results for the profitability factor depend on the true source of its return enhancement:

“As of now, the evidence is quite mixed on whether returns from highly profitable stocks are risk-based or behavioral. If it’s based on risk, then we’d expect it to persist as the … small cap and value premiums have. If it’s behavioral, [investors] may ‘wise up’ and the premium will disappear, or we could continue to make the same mistakes—undervaluing the most profitable companies—and the premium will persist.”

Despite uncertainty about the source of return enhancement, Nelson is still a fan of the stocks of profitable companies.

“Even if the profitability premium is smaller or goes away in the future, it may still be worthwhile to target, as profit and value tend to move opposite each other, giving rise to a diversification benefit—as witnessed by higher returns and lower risk in the data,” he says.

If the factor proves to be lasting, Nelson offers a valuable insight: that investors can lower portfolio risk through the addition of return-enhancing stocks, something traditionally done through the inclusion of bonds which lower risk but which dilute expected portfolio returns.

While higher returns and lower risk in theory suggests that advisors can rev up their portfolios with stock-only allocations, Nelson hasn’t changed his own clients’ bond allocations.

The Servo advisor neutralizes bonds’ tax consequences through “asset location,” that is keeping bonds mainly in clients’ tax-protected IRA accounts.

“I’m mainly looking at it as a potential boost‎ to our stock allocations—higher overall returns with a slightly smoother ride and without as much of the abrupt underperformance when value/small underperform—profitability inclusion helps dilute that somewhat,” he says.

In a nutshell, he adds, including profitability in clients’ portfolios makes “the pre-retiree or retiree’s job just a little easier … which is always a good thing!”