One of the investment themes gaining momentum for 2025 is the return of value investing as a path to much-needed diversification and potentially outsized returns. A focus on quality within value is equally ringing loud.
Let’s add to that profitability.
Value investors know from experience that betting on value has been more a labor of love than a winning strategy in the past decade or so. It has tested conviction and commitment alike. But it could be that the new calendar year ushers in a new opportunity for value. That opportunity could benefit or be enhanced by another important factor: profitability.
The profitability factor is, in many ways, intuitive but surprising. According to Professor Robert Novy-Marx, whose research identified the profitability factor (which was popularized in his paper The Other Side of Value: The Gross Profitability Premium published in 2012), profitability is simply about the outperformance of the most profitable companies relative to the least profitable.
“Profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market predicting the cross-section of average returns. Profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios,” his paper reads.
I had the opportunity this week to talk to Prof. Novy-Marx, who is a professor of finance at the University of Rochester and a consultant to Dimensional Fund Advisors, as well as Lukas Smart, senior investment director at Dimensional. We covered a lot of ground about how this factor works and how it impacts factor models and portfolios. Our wide-ranging conversation about profitability can be heard here.
But consider some quick highlights as you head into the holiday season and mull investment style and factor decisions for the new year. The gist is that profitability can not only enhance a traditional value strategy, it could be the ultimate quality strategy too.
Profitability needs to be measured broadly
To grasp this factor, one needs to measure profitability very broadly, according to Prof. Novy-Marx. That means going beyond bottom-line earnings to capture enterprise measures as well as operating profitability to fully assess a company’s profitability relative to its peers and across industries.
“You can have negative earnings and be broadly profitable” as a business, he says. Think early-days Amazon as an example of that.
When measured broadly, profitability proves to be a reliable premium where most profitable companies consistently outperform their least profitable peers across time horizons. (Our webcast linked above has great data tables showcasing that — check it out!)
Profitability is “synergistic” with value factor, and it makes value investing “smoother.”
Profitability tends to tilt toward growth companies. In other words, the most profitable companies tend to have a growth tilt. That makes profitability an interesting complement to a value strategy.
Perhaps more importantly, as Prof. Novy-Marx puts it, “profitability makes the price signal in value more informative.” Why? Because value is typically purely price-based. Low prices mean a company is either looking at low cash flows or high expected returns. The first may be a value trap, while the latter a value opportunity. Profitability can help you distinguish between the two.
“When you buy based on price alone, you get a portfolio that has not performed in the last 10 years but has, over a longer period, outperformed despite holding firms that on some dimensions looked ugly,” he says. “Profitability gives you information about cash flows, and once you know that, the price signal is more informative about the discount rate.”
Profitability and value are negatively correlated.
Profitability is quality, but is quality the same as profitability?
And profitability “lives in the quality bucket,” according to the professor. But the real question is, what’s quality anyway? Beyond profitability, what makes a company a quality name? There’s no one single definition of quality as a factor.
What’s interesting in the research is that the data shows that quality strategies, too, have a growth tilt, but the outperformance tied to the quality factor is often linked to profitability and little else.
“All of the things we call quality are ways to get a tilt to profitability,” Prof. Novy-Marx said. “If you trade profitability directly, other measures of quality don’t really add anything else. Profitability is a quality strategy but other quality strategies are inefficient ways to get to profitability.”
His research suggests that profitable companies are quality names, but quality as a broader category may be more about compelling marketing for growth rather than significant sources of reliable outperformance. In other words, if you are pursuing quality stock portfolios, look under the hood.
ETF Implementation
Investors looking to capture profitability in their portfolio have ETFs to choose from, including Dimensional’s US High Profitability ETF (DUHP ), which is anchored on this profitability research. The two-year-old ETF, commanding more than $7 billion in assets, holds a lot of familiar — profitable — names among top holdings, including Nvidia, Microsoft, Apple, as well as Costco and Home Depot.
You can find a list of quality-focused ETFs here. Value ETFs can be found here. And to listen to the entire conversation with Prof. Novy-Marx, check out our webcast replay here.
Happy investing! And Happy Holidays!
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