CHICAGO (Reuters) – It’s well known that small-company stocks have outperformed large-company stocks in terms of average annualized return since the 1920s, and bargain-priced stocks tend to outperform growth stocks.
Now there’s another factor worth watching: direct profitability.
Recent research by money management firm Dimensional Fund Advisors (DFA) shows a significant premium over time for investing in companies with high direct profitability – and you can adjust your portfolio accordingly to reap those outsized gains.
DFA’s definition of direct profitability is a bit technical: operating income before depreciation and amortization minus interest expense. In non-accounting terms, companies with high direct profitability are expected to have better returns than those with lower direct profitability.
In a paper recently released by Austin, Texas-based DFA, researchers Gerard O’Reilly and Savina Risova found that a group of high-profitability stocks outperformed a low-profitability group in terms of annualized average return by more than 5 percentage points over the period 1975-2012 – 17 percent vs. 11.7 percent.
For non-U.S. developed and emerging markets, the premiums were even greater – 5.4 percent and 6 percent, respectively.