Key Points:
- Profitability metrics may not provide downside protection during bear markets.
- Incorporating conservatism as an additional quality dimension can reduce downside risk.
- Profitability strategies failed to provide downside protection in historical analysis.
- Combining profitability with conservatism resulted in better risk-adjusted returns.
- Conservatism includes factors such as low leverage and strong balance sheets.
Introduction
When searching for high-quality stocks, profitability metrics are often the main focus. However, profitability is not a defensive factor and may expose investors to unintended risks such as aggressive profit-chasing. To mitigate these risks, incorporating conservatism as an additional quality dimension can reduce a portfolio’s downside risk and enhance its risk-adjusted returns over the long run.
Profitability Isn’t “Defensive”
Profitability and quality are often used interchangeably, but quality extends beyond simple profitability. While influential academic studies feature profitability as an equity factor, it may not offer similar downside protection. Historical analysis of various profitability metrics showed positive excess returns but also higher maximum drawdowns and downside capture ratios, indicating a lack of downside protection.
The Case for Conservatism
Profit-centered views of quality can lead to higher downside risk due to excessive leverage and aggressive business models. Incorporating conservatism into the quality design can minimize these risks. Conservatism looks for firms with high profitability levels that also exhibit financial conservatism, such as lower leverage, stronger balance sheets, and more conservative asset growth.
Profitability vs. Conservatism during Crises
During market crashes like the Global Financial Crisis in 2008 and the COVID-19 crisis in 2020, profitability metrics generated negative return spreads, while conservatism metrics had positive return spreads. This indicates that conservatism can provide better downside protection during periods of market stress.
Convexity of Factor Returns
Scatter plots and fitted polynomial curves demonstrated that combining profitability with conservatism improved the convexity of factor returns. The positive convexity, or smile effect, indicates a defensive feature that drives the factor’s outperformance in both up and down markets.
The Profitability Plus Conservatism Factor
The Profitability Plus Conservatism portfolio offered better downside protection and risk-adjusted returns compared to simplistic profitability metrics. It had a lower maximum drawdown and higher risk-adjusted returns, indicating the benefits of incorporating conservatism into the quality design.
Conclusion
While profitability and quality may be treated as synonyms in academic literature, they are not analogous. Profitability-focused approaches may not provide much of a safety net during crises. Incorporating conservatism as an additional quality dimension can potentially deliver higher risk-adjusted returns by minimizing downside risks associated with excessive leverage and aggressive business models.
