Do Stocks With Higher Profitability Earn More? by Bargain Value
Profitability tells us how good a company manages its equity/assets. There are many formulas to count profitability, but they all are quite correlated with each other. Main 3 formulas are:
Return on Equity (ROE) = annual net profit / equity
Return on Assets (ROA) = annual net profit / total assets
ValueWalk's Raul Panganiban interviews Kirk Du Plessis, Founder and CEO of Option Alpha, and discuss Option Alpha and his general approach to investing. Q1 2021 hedge fund letters, conferences and more The following is a computer generated transcript and may contain some errors. Interview with Option Alpha's Kirk Du Plessis
Return on Capital Employed (ROCE) =
= annual operating profit / (total assets – current liabilities)
Capital employed is something between equity and assets. It gathers only those assets, which can be used to create profits (that is why we subtract current liabilities). ROCE uses operating profits instead of net profits, which I find as a benefit, because they are less prone to manipulations and statistically reflects main trend better. That is why for our todays analysis we will use ROCE.
All the rules will be the same as always. For now we’ve already gathered information about:
- price / sales
- price / book value
If you wish to get more info about methodology used in tests, please go to the first analysis (price/sales).
As always we will split the market into 10 portfolios. In earlier value analysis the first folio was the cheapest one. In todays profitability analysis the first folio will be the most profitable. For better intuitive understanding we can call them:
- Extremely profitable stocks
- Very profitable stocks
- Profitable stocks
- Quite profitable stocks
- Slightly profitable stocks
- Stocks slightly less profitable than median
- Stocks quite less profitable than median
- Stocks less profitable than median
- Stocks much less profitable than median
- Stocks extremely less profitable than median
These are the capital curves for these folios:
1. (Extremely profitable stocks)
10 (Stocks extremely less profitable than median)
Here is the table with annual profits compared with un-weighted market index (which annual profit is 11,77%).
And here is the chart showing data from first column:
We can see that investing in profitable stocks (folio 1-5) allowed us to earn more than investing in the least profitable stocks (folio 6-10). We can see quite stable trend in folios 1-5, showing that with higher ROCE comes higher earnings for investor. From this chart we can conclude that the best investment should be stocks with ROCE over about 14%.
We have to remember that such tests can be inaccurate if one of those happens:
- Folio profit is generated by very small amount of superb stocks. If this is the case, we could have a problem in real world, because missing few buy signals can turn our good strategy into terrible one. Truly good strategy gains its profit from many investments, so if we miss few of them, total profit should change much.
- The same problem could happen with time. It is possible that all profits in folio come from a very short period of time (e.g. march-april 2009 when markets were recovering after great bear market). If this is a case, there is a problem if we would start our investments after this great earning time. It is possible that if we cut of this superb period of time the strategy won’t be good at all. Truly good strategy should gain profits better than un-weighted index for most of the time.
- It is easy to boost profits with doubling our position size. What many can’t see, is that with such move, we also double the risk. Risk sometimes materializes (as loses) and sometimes not. If folio is earning a lot, it could just mean that it is put out for a high risk, but the risk didn’t materialize this time. Some of the riskiest strategies have very stable capital curves for a long time, but when it comes to a severe bear market they just collapse. Truly good strategy shouldn’t lose much more than un-weighted index even during huge bear market.
Let’s check how folios divided by ROCE handles these 3 aspects:
- Diversity between stocks
To check if the profit doesn’t come from just a few good stocks, which earned hundreds of percent, let’s see how pearls (stocks which will earn +50% in next year) were distributed between folios.
Here is a first surprise. If ROCE wouldn’t influence a chance to find a pearl, the bars should be more or less equal at 10%. (10% of all pearls should be in each folio). Here we can se that folios from 2 to 8 have less than 10% of pearls. Folio nr. 1 is above that border, but just a little. The biggest density of pearls is in last two folios (nr. 9-10). It means that the easiest way to find a pearl is to seek in stocks with ROCE < 5%. This conclusion doesn’t fit with our earlier findings that high ROCE folios earn more.
Let’s see how poor performers (stocks which will lose at least -33% in next year) are distributed within folios.
Here we have a next surprise. There is no trend in data. They are gathered more or less around the 10% level, which means that ROCE won’t help us excluding bad stocks.
Let’s combine those two chart in one showing the difference between pearls and poor performers distribution:
We can see that the best pears vs poor performers ratio can be found in folio nr. 9 and 10. All five most profitable folios (1-5) are just average if it’s about finding pearls and avoiding bad stocks. It means that high profits for folios 1-5 were generated by not as many stocks as it should be.
- Diversity between time
In this section I’ve checked for how many 1-year periods each folio was better than un-weighterd index. Good folios should be better than index at least for 50% of time.
Here we have no surprises. First five folios (nr. 1-5) are over the border of 50%. The trend is easily seen, which means that high profitability folios beat the market more often than the rest of them.
- Too much risk test
Here we will check how badly folios performed during their worst year. Values are compared to un-weigthed index, so if the market went down for -10% and our folio for -30%, the result will be -20%.
Very nice trend. That is what we could expect from good indicator. The most profitable folios (1-4) lost only 7% – 9% more than the market. It’s a very good result. Less profitable folios lost much more, which makes them hard to follow in the real world (It’s extremely hard to keep with strategy if it looses for instance 30% more than index).
Today we’ve seen contradictory results. On the one hand the most profitable stocks (as collective) earned more than the market, but on the other, the least profitable stocks contains much more pearls, than average for the market.
My judgement is that high ROCE is better (at least 15%), but we shouldn’t use this indicator standalone. High profitable stocks give an edge, but it’s not as sharp as one in our earlier analysis.