Conservatism: De-Risking the Profitability Issue

Profitability metrics are sometimes the primary focus within the seek for high-quality shares. However Profitability is just not a defensive issue and will expose traders to an organization’s aggressive profit-chasing, amongst different unintended dangers.

So, how can such dangers be mitigated? By incorporating an extra high quality dimension that we classify as Conservatism. By combining Profitability and Conservatism, we will scale back a portfolio’s draw back threat and improve its risk-adjusted returns over the long term.

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Profitability Isn’t “Defensive”

Profitability and High quality are sometimes used interchangeably. That’s comprehensible. A number of influential educational research, together with Eugene F. Fama and Kenneth R. French’s five-factor model, function Profitability as an fairness issue. Exterior of academia, nevertheless, High quality has a broader definition that extends past easy Profitability. Thematically, High quality is a “defensive fairness issue” that ought to present draw back safety throughout bear markets.

This raises the query: Does Profitability supply related draw back safety? To reply this, we examined the historic efficiency of varied issue methods utilizing a number of standard trade Profitability metrics. These embody Fama and French’s Revenue, Return on Fairness (ROE), Return on Invested Capital (ROIC), and Return on Property (ROA). We sorted and ranked all shares inside the Russell 1000 universe in response to their Profitability scores after which constructed factor-mimicking portfolios by taking the primary quintile of shares with the very best scores and weighting them equally. We rebalanced the issue methods on a month-to-month foundation and calculated their efficiency from January 1979 to June 2022. 

Historic Efficiency of the Profitability Issue

  Fama–French Revenue ROE ROIC ROA Russell 1000
Annualized Return 14.2% 14.2% 14.0% 13.4% 10.1%
Annualized Volatility 17.2% 17.4% 17.1% 17.3% 15.3%
Sharpe Ratio 0.58 0.58 0.57 0.53 0.39
Most Drawdown –53.6% –55.3% –53.0% –61.6% –51.1%
Upside Seize Ratio 1.12 1.14 1.12 1.08
Draw back Seize Ratio 1.03 1.05 1.03 1.02
Supply: Northern Belief Quant Analysis, FactSet, Russell 1000, January 1979 to June 2022

Our evaluation exhibits all 4 Profitability methods generated optimistic extra returns relative to the Russell 1000. However all of them skilled larger most drawdowns than the benchmark and had a draw back seize ratio over 1. As such, the Profitability methods failed to supply draw back safety. 

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The Case for Conservatism

These outcomes show that the profit-centric view of High quality can result in larger draw back threat. Why? As a result of the overemphasis on Profitability encourages corporations to tackle extreme leverage and conduct empire-building actions, amongst different profit-chasing pursuits. A worthwhile however extremely levered agency might have higher default or chapter threat when monetary stress will increase amid financial crises. 

Minimizing such dangers requires a multi-dimensional method that comes with Conservatism into the High quality design. We search for corporations with excessive ranges of profitability that additionally exhibit higher monetary conservatism. Which means decrease leverage, stronger stability sheets, extra conservative asset development, and so on. 

For instance the method, we examined the efficiency of varied Profitability and Conservatism metrics in the course of the International Monetary Disaster in 2008 and the COVID-19 disaster in 2020. The next chart exhibits the annualized return spreads between equally weighted high and backside quintile factor-mimicking portfolios in the course of the market crashes. We discovered that Profitability metrics generated adverse return spreads. For example, ROE, ROIC, and ROA had return spreads of –25% to –37% in the course of the current COVID disaster. Against this, all Conservatism metrics had optimistic return spreads throughout each stress occasions.

Profitability vs. Conservatism throughout Crises

Word: Prudent Capex Progress prefers low CAPEX development over excessive CAPEX development.
Supply: Northern Belief Quant Analysis, FactSet, Russell 1000

Subsequent, we demonstrated the defensive attribute of Conservatism with scatter plots and fitted polynomial curves for each Profitability and Profitability Plus Conservatism. The fitted curves illustrate that the convexity of Profitability improved from –0.11 to +0.04 when it was mixed with Conservatism. The optimistic convexity, or smile impact, is the defensive function that drives the issue’s outperformance in each up and down markets.

Convexity of Issue Returns

Word: Profitability relies on composite metrics of ROA, ROE, ROIC, and Revenue. Conservatism relies on composite metrics of CAPEX development, Leverage, and Money Holdings.
Supply: Northern Belief Quant Analysis, FactSet, Russell 1000

Lastly, we up to date the primary chart by including our Profitability Plus Conservatism portfolio. We discovered that the composite issue supplied significantly better draw back safety and risk-adjusted returns than the extra simplistic Profitability metrics. The Profitability Plus Conservatism portfolio had a decrease most drawdown and better risk-adjusted returns.

The Profitability Plus Conservatism Issue

means +
14.2% 14.2% 14.0% 13.4% 14.1% 15.0% 10.1%
17.2% 17.4% 17.1% 17.3% 16.9% 16.6% 15.3%
0.58 0.58 0.57 0.53 0.58 0.65 0.39
–53.6% –55.3% –53.0% –61.6% –51.8% –49.0% –51.1%
1.12 1.14 1.12 1.08 1.10 1.13
Draw back
1.03 1.05 1.03 1.02 1.01 0.99
1. Composite profitability consists of equally weighted Fama–French Revenue, ROE, ROIC, and ROA;
2. Profitability with Conservatism consists of equally weighted profitability metrics and conservatism metrics.
Supply: Northern Belief Quant Analysis, FactSet 


Educational literature might deal with Profitability and High quality as synonyms, however our analysis exhibits they’re removed from analogous. Excessive-Profitability shares can endure from extreme leverage, aggressive enterprise fashions, and so forth. When crises come, they might not present a lot of a security web.

However Conservatism can add that additional dimension to High quality, one that may probably ship larger risk-adjusted returns.

Additional Studying

Fama, Eugene F., and Kenneth R. French. “The Cross-Section of Expected Stock Returns. The Journal of Finance.

Novy-Marx, Robert. “The Other Side of Value: The Gross Profitability Premium.” Journal of Monetary Economics.

Hsu, Jason, Vitali Kalesnik, and Engin Kose. “What Is Quality? Monetary Analysts Journal.

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All posts are the opinion of the creator. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the creator’s employer.

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Daniel Fang, CFA

Daniel Fang, CFA, is a vp at The Northern Belief Firm, Chicago and senior quantitative analysis analyst liable for quantitative fairness, mounted earnings and multi-asset technique analysis, design, and growth. Fang brings greater than 13 years experiences in quantitative finance in areas of quantitative analysis, portfolio administration. and threat modelling. Previous to becoming a member of Northern Belief, Fang was a analysis analyst at Nuveen Investments the place he co-managed two earnings funds and labored on asset valuation and asset allocation analysis. Previous to Nuveen, he spent 4 years at Allstate Investments as a quantitative researcher targeted on asset allocation, by-product modelling, and threat administration. Fang began his profession in finance at Group One Buying and selling, a CBOE designated choice buying and selling agency in Chicago, in 2009. He has a grasp’s diploma in monetary arithmetic from the College of Chicago and a BA diploma in hydraulic engineering from Tsinghua College, China. Fang additionally studied in a doctoral program in civil engineering on the Georgia Institute of Know-how.

Rob Lehnherr, CFA

Rob Lehnherr, CFA, is head of quantitative fairness analysis at Northern Belief Asset Administration. He’s liable for NTAM’s factor-based analysis and product growth. Previous to becoming a member of Northern Belief, Lehnherr was a member of the asset allocation analysis group at Allstate Investments, LLC. He acquired an MBA from the College of Chicago as an Amy and Richard F. Wallman Scholar, with concentrations in analytic finance and econometrics. Lehnherr has a bachelor’s diploma from the College of Iowa the place he studied pc science. He’s a member of the CFA Society Chicago.