Factoring Profitability

Abstract

Recent studies in financial economics posit a connection between a gross prof- itability strategy and quality investing. We explore this connection with two widely used factor models. The first is the four-factor Fama-French-Carhart model, which is a mainstay of empirical research in academia. The second is the Barra USE4 multi-factor model. Our findings are: Consistent with results reported by other researchers, the Fama-French-Carhart model does not provide a satisfactory replication of the gross profitability strategy over the period July 1995-December 2012; Over the same period, the Barra USE4 multi-factor model, which is a standard for practitioners, replicates a substantial portion of the gross profitability strategy with quality and momentum factors; The book to market factor, which is one of three value factors in the Barra USE4 model and the only value factor in the Fama-French-Carhart model, does not make a significant contribution to the gross profitability strategy; However, the Barra USE4 earnings yield factor, which is another measure of value, does make a significant contribution to the gross profitability strategy.

Importantly, our results rely on relatively short data histories. More time is required to determine their efficacy in the long term.

Keywords: gross profitability, quality, factor model, value, earnings yield, book to market, momentum, factor replication

JEL Classification: G11, G12