Profitability Factor: Why the Most Profitable Companies Deliver Higher Returns

1What Is the Profitability Factor?

Profitability as a factor emerged from a puzzle: if value stocks (cheap stocks) outperform, shouldn't expensive stocks (which tend to be highly profitable) underperform? Novy-Marx showed the opposite — expensive, highly profitable companies actually earn higher returns than cheap, unprofitable companies. Both the value and profitability premiums are real, which means the most powerful strategy combines them: buy cheap AND profitable companies.

The profitability factor measures how efficiently a company converts its assets or revenue into profit. The key insight is that profitability tends to persist — companies with high margins today are likely to maintain high margins over the next 3-5 years. The market consistently underestimates this persistence, creating a systematic mispricing that patient investors can exploit.

Fama and French recognized the importance of this finding by adding profitability (RMW — Robust Minus Weak) to their five-factor model in 2015. This formalized profitability alongside market beta, size, value, and investment as the five core drivers of stock returns.

The profitability factor is closely related to — but distinct from — the quality factor. While quality encompasses profitability plus balance sheet strength plus earnings stability, the profitability factor isolates the pure profit-generation component. In Stoquity's model, profitability serves as a primary signal within the broader quality composite.

2Key Metrics & How to Measure It

Stoquity measures profitability through four complementary lenses, from the broadest (gross profit) to the most specific (return on invested capital):

3Historical Performance & Market Cycles

The profitability factor has been one of the most consistent performers across market cycles. Unlike value (which suffers extended drawdowns) or momentum (which crashes during reversals), profitability delivers relatively steady returns with modest cyclicality.

Profitability tends to outperform during defensive market environments — recessions, corrections, and periods of economic uncertainty. This makes intuitive sense: when growth slows and revenues stagnate, companies with high margins can maintain earnings better than low-margin competitors. High-profitability companies are also less likely to face financial distress during downturns.

The factor slightly lags during speculative growth rallies when investors are willing to pay any price for revenue growth, regardless of profitability. The 2020-2021 boom in unprofitable tech companies was a textbook example — companies with negative margins outperformed profitable ones by wide margins, only to crash spectacularly in 2022.

4Academic Foundation

Robert Novy-Marx's 2013 paper "The Other Side of Value" was a watershed moment in factor investing. He demonstrated that gross profitability — a simple ratio of gross profit to total assets — predicts stock returns with statistical power comparable to the value factor. The profound implication: the value and profitability premiums are independent and additive. Buying cheap, profitable stocks dramatically outperforms either strategy alone.

Fama and French incorporated this finding into their five-factor model (2015), adding RMW (Robust Minus Weak profitability) alongside the existing market, size, value, and investment factors. They found that RMW explained a significant portion of return variation that the three-factor model left unexplained.

AQR's extensive research on the "Quality Minus Junk" factor further refined the profitability signal, showing that combining multiple profitability metrics (gross profit, operating efficiency, cash flow generation) creates a more robust signal than any single measure. Their global dataset confirmed the premium exists across 24 developed and emerging markets.

5How Stoquity Uses the Profitability Factor

Stoquity combines gross profitability, operating margin, ROIC, and net margin into a composite score, ranked within sector peers.

Example: Top-Scoring Stocks

Portfolios Using This Factor

6Limitations & Common Pitfalls

The profitability factor has genuine limitations:

• Cyclical distortions — Profitability metrics for cyclical companies vary enormously across the business cycle. A mining company may have 40% margins at the peak and negative margins at the trough.
• Accounting differences — Companies in different industries or countries use different accounting standards, making cross-sector profitability comparisons unreliable without adjustment.
• Backward-looking — Profitability metrics reflect what the company has already achieved, not what it will achieve. Disruption can erode margins faster than historical data suggests.
• Excludes growth companies — Many excellent companies are intentionally unprofitable during their high-growth phase (investing in market share). The profitability factor misses these opportunities.

7Combining Profitability With Other Factors

Profitability + Value is the most powerful academic combination — buying cheap, profitable stocks has delivered approximately 8% annual alpha in back-tests. Profitability + Momentum captures companies whose improving profitability is being recognized by the market. Profitability + Size finds overlooked small-cap quality companies.