One of the newest academic investment strategies is to seek companies that have high levels of profits. Finance professors have previously identified value, size, momentum and liquidity factors (among others) as helping to explain stock-market returns. Now, some argue profitability--also called quality, defensive or even "Buffettesque" factors--should be added to the list. According some academic research, buying companies that have high levels of profits leads to higher future returns.
That seems to be basic common sense, right? Buying better companies leads to better future performance. However, investment experience teaches otherwise. Generally, buying the stocks of attractive companies, as measured by earnings or revenue growth, leads to worse returns than does buying the stocks of the dogs. Good companies are easy to own, which tends to make them overpriced. Understanding this counterintuitive finding is a key distinction between the beginning and intermediate fund investor.
Which makes this finding a head-scratcher. It's hard to believe that investors pile into fast-growth companies but are so unimpressed with high-profitability companies that the latter are underappreciated. For this, the academics have no real answer. They mutter about "risk factors" or "behavioural effects," but there's nothing risky about owning companies that are minting money and have (relatively) cheap stock prices, nor is there anything in behavioural research that seems to fit the explanation.
On the other hand, who am I to contradict Morningstar's equity researchers? They've been carrying on about economic moats for 15 years now--a moat being a competitive advantage that permits a company to enjoy high profit margins on an ongoing basis. In other words, profitability. Morningstar's definition of moat differs from the concept of profitability used in academic research, but clearly there's overlap between the two. And in its short history, a public fund that trades in Morningstar's moat strategy--ELEMENTS Morningstar Wide Moat Focus ETN (WMW)--has fared pretty well.
So, I am torn. I don't understand the logic for this strategy. It's easy to see how money can be made buying loathsome firms that others detest, or by providing liquidity to a market by buying thinly traded stocks. I can't for the life of me understand why buying high-profit companies would work. But the numbers have been there. Let's call it a draw for now, and keep watching.
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