There are fewer return differences if we eliminate the unprofitability of large and mid-caps.

This article will be a short one.

In [Does Eliminating Unprofitable Small Caps Improve Long Term Small Cap Index Performance?]I wanted to find out if we can get better returns if we can systematically create an overall profit/cash flow that is more profitable, by eliminating the companies that don’t have profitability.

It became easy when we got access to index data from Russell, courtesy of Dimensional’s advisor resources.

By taking a long on the 1-, 5-, 10-, and 15-year annualized returns of the S&P 600 Small Cap Index minus the Russell 2000 Index, we see that eliminating unprofitable companies has greatly contributed to the S&P 600 Index outperforming the Russell 2000 Index over time. In recent years, the Russell 2000 has come under increasing criticism as there are more and more unprofitable companies (mainly because of the large amount of biotechnology).

I wanted to be more comprehensive and look at other segments instead of just the US small caps. That’s why I wanted to look at the large caps.

Looking only at large caps is not that easy because the Russell 1000 index focuses on the 1000 largest companies of the Russell 3000 index. That includes midcaps.

Fortunately, we have the S&P 900 index, which includes the companies from the S&P 500 (large caps) and S&P 400 (mid caps).

The S&P 900 includes the 500 large-cap stocks and 400 mid-cap stocks in the United States. They must have positive GAAP earnings in the most recent quarter and over the past four quarters.

The Russell 1000 includes the 1000 largest companies in the United States. There is no profitability screen.

The Russell 1000 is more diversified and also includes some smaller companies. The S&P 900 covers 90% of the US stock market, while the Russell 1000 covers 92% of the US stock market.

The following chart shows the one-year performance of the returns of the S&P 900 (capital growth + dividends) minus Russell 1000:

When returns are above the zero line, the S&P 900 outperforms the Russell 1000 and vice versa.

We notice that most times… it does note that Russell 1000 did better.

Now let’s move forward five years:

Aside from the dotcom boom period, the Russell 1000 has outperformed over the longer term.

Here’s 10 years:

Now we increasingly see that the Russell 1000 is doing better.

Here’s 15 years:

Does this mean that eliminating unprofitable businesses won’t yield much?

I think the large cap stocks are primarily profitable. Removing the unprofitable businesses works better for the smaller businesses because they simply have more unprofitable businesses.

The magnitude of the difference in the above graphs is very, very small.

Perhaps the biggest difference will be increasing profitability, rather than trying to eliminate unprofitability. The evidence there shows that if we have a systematic strategy that buys higher profitability, and invest for the long term, we get better returns:

Fama & French (2015) – “A five-factor pricing model”

• Introduced the RMW (robust minus weak) profitability factor.
• Found that companies with high operating profitability earn higher average returns than unprofitable companies, even after controlling for size and value.
• Profitability explains a significant part of the cross-section of expected returns.

Novy-Marx (2013) – “The other side of value: the gross profit premium”

• Showed that gross profitability (sales minus cost of goods sold) predicts future returns almost as strongly as book-to-market (value).
• Companies with high profitability deliver value-like returns of growth-like risk.
• Gross profitability is more persistent than net income and less affected by accounting noise.

Ball, Gerakos, Linnainmaa and Nikolaev (2016) – “Profitability deflation”

• Confirmed profitability as a robust return predictor for different profitability definitions.
• Showed that controlling for accounting choices and scale effects strengthens the relationship between profitability and returns.
• The effect is strongest among small and medium-sized companies.

Hou, Xue and Zhang (2015) – “Digestive Abnormalities: An Investment Approach”

• Built a model that links company characteristics to expected returns via profitability and investments.
• Found that Higher expected profitability predicts higher expected returnsin accordance with rational pricing.

Here are the more industry-based studies:

S&P Dow Jones Indices – “A Tale of Two Benchmarks” (S&P 600 vs. Russell 2000)

• S&P 600 requires profitability for inclusion; Russell 2000 does not.
• Over long periods, S&P 600 outperformed Russell 2000 with lower volatility.
• Profitability screen credited as the main driver of the performance gap.

WisdomTree – “Generating passive alpha at the core of a US stock index”

• Shown to reweight or exclude stocks with low profitability improves risk-adjusted returns.
• Consistent benefit found across large, medium and small business segments.
• Concluded that filtering profitability reduces downside risk without sacrificing exposure to economic growth.

Research Partners – Quality and Profitability Factors

• Found profitability to be one of the strongest quality indicators.
• Companies with high profitability deliver superior risk-adjusted returns worldwide.
• It is suggested that portfolios of ‘quality minus junk’ (high profitability, low debt, stable profits) will perform better over time.

About internationals:

Fama-French (2020, global evidence)

• Found the The profitability premium is persistent across all regions (US, Europe, Japan, emerging markets).
• The return effect of profitability is similar in magnitude to the size effect, but smaller than value.

Fama & French (2016) – International evidence

• The profitability premium also exists in developed markets outside the US, albeit somewhat weaker.
• Strongest among small and midcap supplies.
• Profitability has a limited effect on large caps (most are already profitable).

AQR Capital Management (Frazzini, Israel, Moskowitz, research 2013-2021)

• Found that consistently quality/profitability factors perform better across all sectors and countries.
• Combining profitability with low debt and earnings stability produces higher Sharpe ratios.

Hopefully you find this useful.

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Kyith worked as an IT Operations Engineer from 2004 to 2019. He currently works as a Senior Solutions Specialist at Insurance Start-up Havend. All opinions expressed on Investment Moats are his own and do not represent the views of Providend.

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