We examine the characteristics and trend of a well-known measure of quality - Profitability. Firstly, we discuss some of the reasons why it is a useful measure and why it might be persistent through time. It is a strong contributor to alpha, both on the long and short sides.
We also see that it has broadly trended down over the last two decades. In particular, global small cap stocks and emerging market stocks have progressively become less profitable. In Australia, we have not seen this decline. It is difficult to construct an economic argument that explains this.
Large cap stocks - notably in North America and more recently in information technology (IT) - have become much more profitable, arresting this broad-based fall but flagging a rotation of profitability into large caps - so are small caps reducing in quality?
Variation by sector and region is also large, underlining the need to apply this measure carefully - neutralising for size, region and sector is critical. The very largest stocks have recently increased in profitability while anything smaller has reduced.
It seems that the broad-based reduction in profitability (NMP1) over time (ex the largest stocks) is due more to a reduction in the proportion of very high profitability stocks than it is attributable to a downward shift in the distribution.
Finally, we note that the most profitable stocks are those with moderate growth expectations but are still on average expensive. The market is willing to pay up for quality over excessive growth so long as growth is maintained.
1 NMP is Novy-Marx Profitability, see PDF.
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