Conservatism: reducing the risk of the profitability factor

Profitability metrics are often the main focus when looking for high-quality stocks. But profitability is not a defensive factor and can expose investors to a company’s aggressive profit-seeking, among other unwanted risks.

So how can such risks be mitigated? By incorporating an additional quality dimension that we classify as Conservatism. By combining Return and Conservatism, we can reduce the downside risk of a portfolio and improve its risk-adjusted return over the long term.

Profitability is not “defensive”

Profitability and quality are often used interchangeably. That’s understandable. Several influential academic studies, including The Five Factor Model by Eugene F. Fama and Kenneth R. French, have Profitability as a patrimonial factor. Outside of academia, however, quality has a broader definition that extends beyond simple profitability. Thematically, quality is a “defensive equity factor” that should provide downside protection during bear markets.

This raises the question: Does Profitability offer similar fall protection? To answer this, we examined the historical performance of various factor strategies using several conventional industry profitability metrics. These include earnings, return on equity (ROE), return on invested capital (ROIC) and return on assets (ROA) of Fama and French. We rank and rank all stocks within the Russell 1000 universe according to their Performance scores and then build portfolios that mimic factors by taking the top quintile of stocks with the highest scores and weighting them equally. We rebalance factor strategies on a monthly basis and calculate their performance from January 1979 to June 2022.

Historical performance of the profitability factor

Our analysis shows that all four Profitability strategies generated positive excess returns relative to the Russell 1000. But all experienced higher maximum dips than the benchmark and had a dip-catch ratio greater than 1. As such, the Profitability strategies could not provide protection against falls.

The case for conservatism

These results demonstrate that a profit-focused view of quality can lead to increased downside risk. Why? Because the overemphasis on Profitability encourages companies to assume excessive leverage, engage in empire-building activities, among other profit-seeking activities. A profitable but highly leveraged company may be at higher risk of default or bankruptcy when financial stress increases amid economic downturns.

Minimizing such risks requires a multidimensional approach that incorporates conservatism in quality design. We look for firms with high levels of profitability that also display greater financial conservatism. That means lower leverage, stronger balance sheets, more conservative asset growth, etc.

To illustrate the process, we examine the performance of various metrics of return and conservatism during the global financial crisis in 2008 and the COVID-19 crisis in 2020. The graph below shows the annualized return differentials between portfolios mimicking top quintile factors and equally weighted lower during market dips. We found that profitability metrics led to negative credit differentials. For example, ROE, ROIC and ROA had return spreads of -25% to -37% during the recent COVID crisis. By contrast, all conservatism metrics had positive performance differentials during both stress events.

Profitability versus conservatism during crises

Next, we demonstrate the defensive characteristic of conservatism with scatter plots and fitted polynomial curves for both Profit and Profit plus Conservatism. The fitted curves illustrate that the convexity of Profitability improved from -0.11 to +0.04 when combined with Conservatism. Positive convexity, or the smile effect, is the defensive characteristic that drives factor outperformance in both rising and falling markets.

Convexity of factor returns

Finally, we update the first chart by adding our Returns Plus Conservatism portfolio. We found that the composite factor offered much better downside protection and risk-adjusted returns than simpler return metrics. The Profitability Plus Conservatism portfolio had a lower maximum drawdown and a higher risk-adjusted return.

The profitability factor plus conservatism

Conclution

The academic literature may treat Profitability and Quality as synonymous, but our research shows that they are far from being analogous. High-yield stocks can be affected by excessive leverage, aggressive business models, etc. When crises hit, they may not provide much of a safety net.

But conservatism can add that extra dimension to quality, potentially leading to higher risk-adjusted returns.

Other reading

Fame, Eugene F. and Kenneth R. French. “The cross section of the expected returns of the stocks.” The Finance Journal.

Novy-Marx, Robert. “The Other Side of Value: The Gross Return Premium.” financial economics magazine.

Hsu, Jason, Vitali Kalesnik, and Engin Kose. “What is quality?” Financial Analysts Magazine.

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All messages are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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