When in search of high-quality stocks, profitability metrics are sometimes the main focus. But profitability shouldn’t be a defensive factor and may expose investors to an organization’s aggressive pursuit of profits, amongst other unintended risks.
How can such risks be mitigated? By including an extra quality dimension that we classify as conservatism. By combining profitability and conservatism, we will reduce a portfolio’s downside risk and increase its risk-adjusted returns over the long run.
Profitability shouldn’t be “defensive”
Profitability and quality are sometimes used interchangeably. That is comprehensible. Several influential academic studies including The Five Factor Model by Eugene F. Fama and Kenneth R. French, feature profitability as an equity factor. However, outside of academia, quality has a broader definition that goes beyond easy profitability. Thematically, quality is a “defensive stock factor” intended to offer downside protection in bear markets.
This begs the query: Does Profitability provide similar downside protection? To answer this query, we examined the historical performance of assorted factor strategies using various industry-standard profitability metrics. These include Fama and French’s earnings, return on equity (ROE), return on assets (ROIC), and return on assets (ROA). We sorted and ranked all stocks inside the Russell 1000 universe by their profitability scores after which created factor-like portfolios by taking the primary quintile of stocks with the best scores and weighting them equally. We rebalanced the factor strategies monthly and calculated their performance from January 1979 to June 2022.
Historical Performance of Profitability Factor
| Fama – French Benefit | ROE | ROIC | LONG | Russell 1000 | |
| Annualized return | 14.2% | 14.2% | 14.0% | 13.4% | 10.1% |
| Annualized volatility | 17.2% | 17.4% | 17.1% | 17.3% | 15.3% |
| Sharpe ratio | 0.58 | 0.58 | 0.57 | 0.53 | 0.39 |
| Maximum drawdown | –53.6% | –55.3% | –53.0% | –61.6% | –51.1% |
| Upside Capture Ratio | 1.12 | 1.14 | 1.12 | 1.08 | – |
| Downside capture ratio | 1.03 | 1.05 | 1.03 | 1.02 | – |
Our evaluation shows that every one 4 Profitability strategies delivered positive excess returns relative to the Russell 1000. However, all of them experienced higher maximum drawdowns than the benchmark and had a downside capture ratio of over 1. Therefore, the Profitability strategies didn’t provide loss protection.
The Argument for Conservatism
These results show that the profit-oriented view of quality can result in higher downside risk. Why? Because the overemphasis on profitability encourages corporations to interact in excessive leverage and have interaction in empire-building activities, amongst other profit-making pursuits. A profitable but heavily indebted company could also be at higher risk of failure or insolvency when financial stress increases during economic crises.
Minimizing such risks requires a multidimensional approach that includes conservatism into quality design. We search for corporations with high profitability that also display greater financial conservatism. That means lower debt, stronger balance sheets, more conservative asset growth, etc.
To illustrate the method, we examined the performance of assorted profitability and conservatism metrics in the course of the global financial crisis in 2008 and the COVID-19 crisis in 2020. The chart below shows the annualized return spreads between equally weighted portfolios that mimic the highest and bottom quintiles during market crashes. We found that profitability metrics resulted in negative return spreads. For example, ROE, ROIC and ROA had return ranges of -25% to -37% in the course of the recent COVID crisis. In contrast, all measures of conservatism had positive return spreads during each stress events.
Profitability vs. conservatism in crises
Source: Northern Trust Quant Research, FactSet, Russell 1000
Next, we demonstrated the defensive properties of conservatism with scatterplots and fitted polynomial curves for each profitability and profitability plus conservatism. The fitted curves illustrate that profitability convexity improved from −0.11 to +0.04 when combined with conservatism. The positive convexity or smile effect is the defensive feature that drives the factor’s outperformance in each rising and falling markets.
Convexity of factor returns
Source: Northern Trust Quant Research, FactSet, Russell 1000
Finally, we updated the primary chart by adding our Profitability Plus Conservatism portfolio. We have found that the composite factor provides significantly better downside protection and risk-adjusted returns than the simpler profitability measures. The Profitability Plus Conservatism portfolio had lower maximum drawdown and better risk-adjusted returns.
The factor of profitability plus conservatism
| Fama– French Benefit |
ROE | ROIC | LONG | Comp osite Benefit- Capability1 |
Benefit- Capability + Preservation Atism2 |
Russell 1000 |
|
| Yearly To return |
14.2% | 14.2% | 14.0% | 13.4% | 14.1% | 15.0% | 10.1% |
| Yearly volatility |
17.2% | 17.4% | 17.1% | 17.3% | 16.9% | 16.6% | 15.3% |
| Sharpe Relationship |
0.58 | 0.58 | 0.57 | 0.53 | 0.58 | 0.65 | 0.39 |
| Maximum Drawdown |
–53.6% | –55.3% | –53.0% | –61.6% | –51.8% | –49.0% | –51.1% |
| Above Capture Relationship |
1.12 | 1.14 | 1.12 | 1.08 | 1.10 | 1.13 | – |
| Disadvantage Capture Relationship |
1.03 | 1.05 | 1.03 | 1.02 | 1.01 | 0.99 | – |
2. Profitability with conservatism consists of equally weighted profitability ratios and conservatism ratios.
Source: Northern Trust Quant Research, FactSet
Diploma
The academic literature may treat profitability and quality as synonyms, but our research shows they’re removed from analogous. Highly profitable stocks can suffer from excessive debt, aggressive business models, etc. When crises come, they could not provide much of a security net.
But conservatism can add an extra dimension to quality that may potentially deliver higher risk-adjusted returns.
further reading
Fama, Eugene F. and Kenneth R. French. “The cross-section of expected stock returns.“.
Novy Marx, Robert. “The other side of the worth: the gross profitability premium.” .
Hsu, Jason, Vitali Kalesnik and Engin Kose. “What is quality?“.
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