Berkin and Swedroe lump two factors, Profitability and Quality, together into one chapter so I’ll do the same with this blog. Beta, Size, Value, and Momentum are the Big Four and now we move into some lesser known factors.
Profitability is of particular interest to me as one of my former students, Robert Novy-Marx, is given credit for uncovering this market anomaly. Profitability applies more to individual stocks and is not as straight forward to define as are size, value, and momentum. To quote Berkin and Swedroe here is a definition of Profitability.
“Profitability, as measured by the ratio of gross profits to assets, has roughly the same power as book-to-market ratio (a value measure) in predicting the cross-section of average returns.” Remember that “cross-section” is equivalent to relative comparisons with other securities.
Profitability and Quality are closely related. The word Quality carries an inherent meaning for most of us, but it does require a definition when it comes to investing. Berkin and Swedroe define Quality as follows.
“High-quality companies have the following traits: low earnings volatility, high margins, high asset turnover (indicating efficient use of assets), low financial leverage, low operating leverage (indicating a strong balance sheet and low macroeconomic risk), and low stock-specific risk (volatility that is unexplained by macroeconomic activity).” That is quite a mouthful of a definition, but you get the idea.
We now have six primary factors with two more to go. The six are: Beta, Size, Value, Momentum, Profitability, and Quality. We now begin our search for securities (ETFs) that fill the requirements of these factors. That comes after we identify the remaining two factors.