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The Four Factor Model

By: Frank Armstrong

In a new working paper, Fama-French extend previous work to offer investors the possibility of capturing additional returns.

It’s almost universally agreed that relative to the market as a whole, investors willing to hold smaller companies or value* companies demand and can expect additional returns (premiums). Further these premiums can be most economically and effectively captured by passive strategies that don’t rely on individual security selection or a forecast of future events. As previously explained here, The Fama-French Three Factor Model has become the standard for explaining stock pricing and expected returns.

But, what if there are additional variables that can refine that model? It turns out that there is at least one additional variable that commands a robust and persistent premium that can be captured by passive strategies.

Any first year finance student knows that a stock is worth the present value of its future dividends (profits). So, it stands to reason that if all other things are equal, a stock with higher expected future profits will have a higher return.

This may seem so obvious that it isn’t even worth mentioning. But, while economists have long understood that there is a link between profits and returns, they had a tough time finding a proxy for a company’s future expected earnings. Without a proxy they couldn’t build a model that made sense.

It turns out the solution is so simple that we all might wonder why we didn’t think of that. If we adjust for onetime accounting adjustments (extraordinary, unusual, special or non-recurring expenses), a company that was profitable last year is highly likely to be profitable this year. And while as we might expect the probability falls as we extend our time horizon out to three, five and ten years, it’s still high enough to be a reasonable proxy for future profits.

So, in any universe of stocks, if we screen out or underweight low profit stocks, we will increase our expected returns going forward. For instance, a small value fund that tilted toward profitable companies within that small value universe would capture additional expected returns. We don’t have to make a prediction about future profitability of a specific firm, we simply overweight yesterday’s high profit firms with the expectation that tomorrow most of them will remain high profit, and that those higher profits will translate into higher stock returns.

The authors believe that the profitably of stocks is an additional dimension of returns that employed effectively in conjunction with the value and size factor can enhance the investor’s results. Significantly the higher returns due to profitability are expected from the dividend discount model long accepted by economic theory.

Back testing indicates that these additional returns over time should be non-trivial in nature. These findings are universal across the world’s asset classes, persistent and robust.

The best news is that the findings can be exploited passively by simply applying an additional screen in any universe of stocks without significantly altering the risk character of the pool.

Dimensional Fund Advisors (DFA) is rolling out an additional series of funds, and modifying other existing funds to capture the benefits of this research. Other fund families will certainly follow.

Disclaimer: The author holds DFA funds for his personal portfolio and utilizes them extensively for clients.

*Value companies are defined as stocks that have a high book to market ratio (price), in other words cheap stocks.