What is the profitability factor in investing? As the name suggests, stocks from profitable companies are expected to outperform unprofitable ones. But that doesn’t mean you should load up on high-flying stocks. In his recent Grand Rapids Business Journal column, Calvin Wiersma, CFP® explains: Like managing a successful rental property, it’s best to consider profitability as one factor among many that contributes to your well-built investment portfolio.
Investing a portion of your wealth in profitable companies makes intuitive sense. For example, a rental house with high rental income and low maintenance expenses will produce higher profits. Consistent higher profits into the future should create a larger return for the property owner.
To a degree, company stocks can work that way too, as suggested by Professor Robert Novy-Marx’s landmark study in a 2013 Journal of Financial Economics. Building on past research, Novy-Marx found, if a company is more profitable than others today, it’s likely to be more profitable than others in the future. And companies with higher profits after they sell a product or service, also tended to have higher future stock returns.
So, why not invest entirely in profitable companies? Profitability is just one of several factors contributing to higher expected returns, and not necessarily the most significant one. In fact, the it pairs particularly well with another important factor: the value factor. As an investor, your end goal is to maximize overall expected returns while minimizing overall investment risks. For that, the profitability factor can serve as one of several pieces in your globally diversified portfolio.
Would you like to learn more about how the profitability factor fits into evidence-based portfolio construction? Read Calvin’s full article here.
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