Firm profitability is a characteristic highly sought out by investors in private market transactions.  In public markets firm profitability tends to be frequently lumped together among “quality” factors.

Over the years I have always thought that “quality” is very much in the eye of the beholder while profitability as a concept can be measured in an unambiguous manner and stand on its own feet.

That is why in our stock selection and top-down sector and country allocation models we treat profitability as a separate conceptual category.

After all what more powerful combination can one have for long-term value creation than a company that is growing and doing so in a profitable way.  Some of the best known stocks in the world such as Apple and Google are living proof that a combination of growth and profitability is highly rewarding for long-term investors.

While market-wide ROE’s tend to be pretty stable across time we would expect some variability caused by the business cycle, the degree of leverage in the system, changes in the cost of money and tax rates among others.  The above chart shows the year-to-year median ROE along with points along the 3^rd and 1^st quartiles.  The average calendar year ROE in our global sample is 11.2 with a standard deviation of 2.1.

The conventional wisdom holds that in a competitive economy it is virtually impossible to remain a highly profitable company over the long-term.

In the case of a frictionless free market system, companies should all gravitate long-term to an economy-wide level of profitability.  The idea is that companies that are currently below a normal level of profitability will restructure and/or change their business strategy thus hopefully improving profitability.  Conversely, companies with above average levels of profitability will face increased competitive forces and revert back over time to a normal level of profitability.

In a free market open economy company profitability will exhibit a mean reverting pattern.  That is in theory. In the real world of partially competitive markets we would still expect to see mean reverting levels of profitability but with a lot more noise. We would also expect to see stronger mean reverting patterns over longer holding periods while in the short-term we would expect to see minimal competitive re-alignment.

In this note we present some high level findings on how Return on Equity (ROE), a common measure of firm profitability, evolves over time. ROE is calculated as Net Income / Shareholder Equity. For some background on what motivated our interest in profitability factors please take a look at a recent video Eric J. Weigel – The Manual of Ideas Interview available on YouTube.

What does the data show in terms of how companies migrate between profitability stages?

Note: Decile 1 contains the highest ROE stocks in our balanced panel global equity sample

Some high level conclusions:

• ROEs do not fluctuate that much over time and there is a high persistence in relative universe profitability rankings. We call this the “status quo” effect
  • Mean reversion in ROE (estimated over a five year window) is best found in the middle portion (Deciles 4-6) of the profitability spectrum

• The highest ROE stocks tend to, over the subsequent five years, remain in the higher portions of our sample profitability at a greater rate than expected.
  • Buying a high ROE stock and five years down the road ending up with a company in the bottom end of profitability occurs with a frequency less than expected by pure chance
  • Deciles 2 and 3 appear to be the place for finding companies with high sustainable levels of relative profitability

• The greatest rate of improvement in relative profitability rankings occurs in Decile 10 comprising those companies with the lowest ROEs, but the rate of improvement fails to beat expectations. Going long Decile 10 stocks is fraught with significant risk of disappointment

• A contrarian investor investing in low relative ROE stocks such as those in Deciles 7-9 is taking a bet with unfavorable odds of success. The improvement rate of these ROE laggards tends to fall below expectations

As a final note, our view is that stock picking is a multi-dimensional endeavor balancing among others valuation, profitability, and growth concepts.  The behavior of any one factor should always be viewed in the context of the current capital market environment.  Our current view on the attractiveness of stock factors augurs well for favorable returns to stocks with high sustainable levels of company profitability.

To read the full report please click here Migration Patterns In Company Profitability

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

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