There has been an incredible amount of research in the past 50 years on how financial markets work – concepts like the risk-return trade-off, the theory of interest, the efficient markets hypothesis – that has led to more sophisticated approaches to capturing equity premiums for investors.
Think of it like how cameras have advanced in recent years. The advances in financial markets science are like the ability to capture images with much greater precision and clarity.
The latest research is on profitability – and how we can identify stocks with higher expected profitability in the market. In terms of investment outcomes, adding profitability considerations to existing strategies can generate a better expected return with lower volatility and greater reliability.
What is profitability?
Valuation theory has long established the connection between expected profits and expected returns.
You would expect that if two companies are trading at the same relative price, the one with higher expected profitability will have higher expected returns. That’s logical, isn’t it?
The problem has been to measuring profitability. How do you identify a company’s future profitability?
And this is the breakthrough. A reliable proxy for a firm’s future profitability has been identified – “direct profitability”, a measure that is related to operating profitability.
The researchers found that after adjusting for size and relative price, stocks with higher direct profitability outperformed stocks with lower direct profitability across different time periods and different markets.
While all this may sound very technical, the principles are simple. Among some of the elements reflected in a company’s share price are what the company owns minus what it owes (its book equity), its expected profits and the discount rate (cost of capital) applied by the market to those expected profits.
So if we hold expected profits fixed, a lower relative price implies a higher expected return for a stock. This refers to the value effect. On the other hand, if we hold relative price fixed, higher expected profits imply a higher expected return.
How might this look in a portfolio?
Let’s take Australian shares as an example. We’ll start with all of the companies listed on the Australian stock exchange – the total market index. In this, you will have an array of stocks that vary in size from very large to relatively small. And you will find stocks which range from a low relative price (often referred to as ‘value’ stocks) to those with a high relative price (‘growth’ stocks). That covers the market, size and relative price dimensions that have historically been key factors in our portfolios.
Now, with profitability, as an investor, you can gain an additional dimension: the ability to select stocks with high expected profitability – which brings the ability to more precisely target the sources of higher expected returns in a portfolio.
All grounded in financial science, not a crystal ball.