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%.