I recently found Novy-Marx's work on the profitability factor through his paper A Taxonomy of Anomalies and their Trading Costs, where he finds that among other factors, a value/profitability factor that uses gross profitability ((revenues-cogs)/assets) produces significant out-performance (here's more of his papers on gross profitability), even with transaction costs taken into account.
His results look pretty robust (not that I understand any of the math). But now everyone's (mostly AQR) using gross profitability in their models. And I wanna make a model that can beat AQR's. My Value/Momentum/Profit one probably does but that's too similar to theirs. So in the spirit of venturing into uncharted territory, let's put momentum aside and focus on value and profitability. I like those two better anyway, they make more sense to me.
So we need value and profitability factors. But we can't copy Novy-Marx's factors (P/B and gross profitability). Down the factor rabbit hole we go!
Value's easy: the enterprise multiple is pretty much the most empirically robust metric I've been able to find. There's a lot more data out there about it but trust me, it works. I'm going to use EBIT instead of EBITDA though because depreciation and amortization matter. Taxes are pretty much the same every year so they're priced in. At least I think that's the theory. AQR uses other factors for value like price to sales and price to cash flow, but let's keep it as simple as it needs to be and no simpler. Or whatever the quote is. Our performance will still be just fine.
So on to this tricky profitability factor. I made sure Novy-Marx's numbers roughly check out, although I'm using the S&P 500 as my index instead of Russell 1000 because I really like liquidity and the ability to scale. I ended up with roughly 14.5% CAGR vs the market's 8.5% from 1996 to now, although it hasn't been too hot recently. Point is, gross profitability works, and it works better with a value metric. Now let's change it. Or at least, try to.
Some other researchers took Novy-Marx's gross profitability idea and changed it to operating profitability, which they said could improve returns over gross profit and also predict returns for up to ten years. I threw it together in Bloomberg to backtest and it didn't seem to improve results much over standard gross profitability. I could definiatley be more robust though: for some reason Bloomberg has SG&A expense data going back only to 2011 (that's just one area where it wasn't a great comparison). Basically, changing to operating profit didn't do much. A bunch of other, later studies, also showed this.
I've tended to want to incorporate cash flow into my factor thinking because it makes sense: if you end up with lots of free cash, you're way better off than not having lots of free cash. The same cannot be said for earnings if you have to reinvest all of them. As it stands though, EBIT/EV seems to be a better predictor of returns than FCF/EV. So I was actually pretty excited when I stumbled across this study that showed really high returns if you use something close to free cash flow/assets as a proxy for profitability. And I tested it on Bloomberg. But not really, because I couldn't come close to figuring out how they got the accounting numbers they wanted. So I left out some probably pretty important subtractions and additions to FCF and tested.
To my disappointment, however, the FCF proxy outperformed gross profitability solo, but significantly under-performed val-prof when combined as val-fcf.
/shrug. Looks like the simple value-profitability strategy is the way to go. I'll take my 14.5% CAGR and beat the index by 6% on average. I'm still looking for some sweet differentiation to crush AQR though.
On a slightly unrelated note, Novy-Marx also found that the momentum anomaly is largely due to fundamental momentum, (earnings improving, etc.) which I'm happy to accept as the intuitive basis for momentum strategies.
Submitted July 20, 2017 at 07:56PM by _Aether__ http://ift.tt/2gOAM9k
