Investors demand higher returns for taking on more risk. Small stocks and value stocks have exhibited performance that exceeds that of the broad market over the long term which can be explained by the increased riskiness of these asset classes above and beyond the risk of the market. The science behind small cap and value is peer reviewed, evidence based, and it makes sense with relation to risk and return. The idea of tilting a portfolio towards expected profitability in pursuit of higher expected returns does not have the same logical flow; how does profitability relate to risk? If a company is profitable, wouldn't the market include that information in the price? To explain this, expected profitability should be thought of as a filter rather than a standalone factor of higher expected returns. When it is applied in conjunction with the size and value factors, the risk story of expected profitability becomes very clear.
All else equal, the market will place a higher relative price on a company with higher expected profitability. If Company A has higher expected profitability and the same relative price as Company B, the market has priced in additional risk in Company A. Holding size and value constant, the additional risk uncovered by expected profitability can be observed in the higher expected returns that these stocks have shown throughout time and across markets. So you can’t treat expected profitability as an asset class like small and value, but once a portfolio has been tilted towards small and value, expected returns can be further increased using profitability as a filter.
The efficacy of this filter is directly observable as it relates to the performance of the small cap growth asset class. This asset class was previously limited in portfolios based on its consistent underperformance and high volatility relative to other asset classes, but it was considered an anomaly that could not be explained by the three factor model. It has now been found that the poor performance of small cap growth companies can be explained by low profitability. This filter adds another cost effective method of pursuing higher expected returns and avoiding low expected returns based on robust data that is persistent through time and pervasive across markets, and it makes sense as related to risk and return.
Original post at pwlcapital.com