Research shows that a company’s current profitability is a powerful predictor of its future cash flows
Quality is a popular style of systematic or “factor-based” investing, not least because quality strategies are said to complement value strategies. But look beyond the appealing name and you’ll notice “quality” is a vaguely defined characteristic. As a result, quality can end up competing with, rather than complementing, value.
Profitability by another name
Since there’s no universally accepted definition of quality, the industry relies on “quality scores” that smush together various proxies for a company’s prospects. Most often, they are a combination of high earnings, low earnings volatility, and low leverage.
Research by academics like Robert Novy-Marx, however, shows that the information about expected returns contained in quality scores is subsumed by the information in measures of a company’s profitability. Essentially, quality is a convoluted way of thinking about profitability.
Why should profitability be related to expected returns?
Valuation theory says a stock’s price equals its expected discounted cashflows, where the discount rate reflects investors’ expected return. Tinker with that idea and you’ll arrive at the implication that higher expected cash flows for a similar price mean a higher expected return.
How do we then pin down expected cash flows? Research shows that a company’s current profitability is a powerful predictor of its future cash flows. As such, more profitable companies should have higher expected returns, all else being equal. This is the logic underlying the profitability premium.
The profitability premium has been documented in the US going back to the 1960s and in international markets (both developed and emerging) going back to the 1990s. So, because research shows that the variables commonly used in quality scores contain little additional information about future cash flows beyond what is already captured by current profitability, we think profitability is all you need.
The other side of value
Valuation theory also implies that, provided expected cash flows are similar, a lower valuation means a higher expected return. This is the motivation underlying the value premium.
Importantly, the theory suggests considering profitability and valuation together provides sharper inference about expected returns than considering either by itself. For this reason, Novy-Marx calls profitability “the other side of value”.
In practice, using profitability instead of quality can help investors avoid redundant characteristics in their systematic strategies. Using quality scores, on the other hand, is like filling your tool box with different gizmos and gadgets that may or may not be useful when you already have a quality multi-tool fit for the job.
Focusing on profitability also allows more control over the interactions with other return drivers when designing and managing strategies. This is important because of the way profitability and value considerations complement one another.
Working in harmony
Focusing on the profitability premium is a great start, but there are ways to improve upon that. In line with valuation theory, a profitability strategy can increase its expected return by emphasising value stocks within the high-profitability space. Conversely, a value strategy can improve its expected return by emphasizing the most profitable value stocks.
Thinking simultaneously about what you pay (valuation) and what you expect to receive (profitability) is both intuitive and prudent.
In addition, highly profitable companies tend to be large and command high valuations, while value stocks tend to be smaller and less profitable. The two strategies can therefore have little overlap in terms of their holdings, implying diversification benefits for investors that combine them in an asset allocation.
Achieving such diversification benefits can be more difficult with a quality strategy. This is because the composite nature of quality scores can lead to unintended interactions and, ultimately, material overlap with the holdings of a value strategy. Instead of acting as a diversifier for value, quality can end up doubling down on it.
The greatest quality
A simple, powerful characteristic like a company’s current profitability appears to be all investors need for getting meaningful exposure to companies with higher expected cash flows. Moreover, a profitability strategy can have a prudent focus on valuation and still be an excellent complement to a value strategy.
Instead of adding together a bunch of characteristics in the hopes of capturing quality, investors may be better off boiling quality scores down to their essence. In that context, profitability may be the greatest quality.
Mamdouh Medhat is a senior researcher and vice president at Dimensional Fund Advisors
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