Are the profitability (Robust Minus Weak, RMW) and investment (Conservative Minus Aggressive, CMA) stock factor premiums observed post-1963 robust in earlier data? In the February 2017 version of his paper entitled “The Profitability and Investment Premium: Pre-1963 Evidence”, Sunil Wahal measures the profitability (revenue minus cost of goods sold, scaled by total assets) and investment (change in total assets) factor premiums using data hand-collected from Moody’s Manual that predates the sample commencing July 1963 used to discover these factors. He defines the premiums conventionally as returns to a portfolio that is each month long (short) stocks with relatively high (low) expected returns. Because of missing older data, inconsistent accounting methods and accounting data availability lag (at least six months between fiscal year end and returns), he starts his accounting data in 1938 and return data in July 1940. Using available firm accounting and monthly return data as specified through June 1963, he finds that:
- RMW has gross monthly average return 0.15% and 3-factor (market, size, book-to-market) alpha 0.41% during July 1940-June 1963, compared to 0.52% alpha reported in other research for data since July 1963. Findings generally hold:
- For a subsample of large stocks.
- After controlling for the value factor. Double sorts on book-to-market ratio and profitability into fifths (quintiles) show that the gross monthly return spread between high and low profitability quintiles within book-to-market ratio quintiles is around 1%.
- For operating profitability (which excludes selling, general and administrative expenses and interest expense) scaled by book equity.
- CMA has gross monthly average return -0.07% and insignificant gross monthly 3-factor alpha -0.02% during July 1940-June 1963. Alpha remains insignificant when:
- Defining the factor based on change in book equity rather than change in total assets.
- Extending the new sample backward to July 1926.
In summary, evidence indicates that profitability (asset growth, or investment) is robust (is not robust) on a gross basis as a stock-picking factor in U.S. samples that precedes factor discovery samples.
Cautions regarding findings include:
- Reported returns and alphas are gross, not net. Accounting for portfolio reformation and shorting costs would reduce performance. Shorting may not always be feasible as specified.
- Gross average monthly return for the profitability factor is an unattractive 0.15%. In other words, a standalone profitability screen does not perform well.
- Firm accounting data may not have been as accessible to investors as later data, such that stock prices may not reflect their widespread use.
