Numerous aspects of stock valuation “all basically bet on the same thing.” What’s that? profitability.
Investing in conservative, high-quality value companies is a terrific way to keep things simple, especially right now.
Too many financial analysts make investing far more difficult than it has to be, either out of ignorance or a desire to draw in business. As an illustration, consider the hundreds of new stock-selection criteria that have been “discovered” in the last 20 years, particularly in light of the underperformance of some conventional criteria like value. This vast and expanding collection has been dubbed the “factor zoo.”
But according to a recent study, a lot of these factors may be reduced to just one: profitability.
captioned “Profitability Retrospective: What Have We Learned?” The study was carried out by Mamdouh Medhat, vice president and research director at Dimensional Fund Advisors, and Robert Novy-Marx, a professor of finance at the University of Rochester. The researchers use the operational profit to book equity ratio to determine a company’s profitability. Revenue less running costs, interest, and cost of goods sold is operating profit.
According to the researchers, concentrating on any of the elements that center on “quality,” including return on equity and earnings volatility, offers little to no additional benefit if you have chosen the most profitable stocks and avoided the least profitable ones.
The study also demonstrated that there is no justification for emphasizing “alternative value” or “defensive” elements like low volatility and low beta, which are attempts to enhance the conventional concept of value by, for example, factoring intangible assets into the book value calculation.
This new study’s authors summarized the findings by saying that the factors in these categories “all basically bet on the same thing.” What’s that? profitability.
The fact that investment firms are constantly searching for new items that appear to be different from others is probably one of the reasons why the “factor zoo” has gotten so crowded. According to a 2023 study published in the Review of Financial Studies, exchange-traded fund providers have launched more specialized services in an effort to set themselves apart from rivals. This, not coincidentally, enables them to demand greater fees.
These suppliers are highly motivated to prevent investors from learning that their pricey products might be nothing more than overpriced portfolios of the most successful businesses.
The “Profitability Retrospective” study’s most evident investing recommendation is to put money into a diverse portfolio of the most successful businesses. The DFA’s US High Profitability ETF DUHP, which has an expense ratio of 0.21%, is one ETF that does this. (Co-author Novy-Marx is a consultant to DFA, while co-author Medhat is employed by the firm.)
The investment implication for stock pickers is to steer clear of the least profitable firms and favor the most profitable ones, which are determined by the ratio of operating profits to book equity, as was previously explained. Ranking all publicly listed equities based on profitability is impossible without access to a large database, but it is reasonably easy to make the computation with a small number of stocks. (When examining any ticker at MarketWatch, the required data points are easily accessible.) You should pick the more profitable stock out of any two that you like equally.
The 15 S&P 500 stocks with the highest operating profitability are listed below. Among the top five are Live Nation Entertainment Inc. (LYV), AbbVie Inc. (ABBV), Verisk Analytics Inc. (VRSK), DaVita Inc. (DVA), and Colgate-Palmolive Co. (CL). Oracle Corp. (ORCL), Apple Inc. (AAPL), and Home Depot Inc. (HD) are all on the list.
