Practical analysis for investment professionals
10 November 2022

Conservatism: De-Risking the Profitability Factor

Profitability metrics are often the main focus in the search for high-quality stocks. But Profitability is not a defensive factor and may expose investors to a company’s aggressive profit-chasing, among other unintended risks.

So, how can such risks be mitigated? By incorporating an additional quality dimension that we classify as Conservatism. By combining Profitability and Conservatism, we can reduce a portfolio’s downside risk and enhance its risk-adjusted returns over the long run.

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Profitability Isn’t “Defensive”

Profitability and Quality are often used interchangeably. That’s understandable. Several influential academic studies, including Eugene F. Fama and Kenneth R. French’s five-factor model, feature Profitability as an equity factor. Outside of academia, however, Quality has a broader definition that extends beyond simple Profitability. Thematically, Quality is a “defensive equity factor” that should provide downside protection during bear markets.

This raises the question: Does Profitability offer similar downside protection? To answer this, we examined the historical performance of various factor strategies using several conventional industry Profitability metrics. These include Fama and French’s Profit, Return on Equity (ROE), Return on Invested Capital (ROIC), and Return on Assets (ROA). We sorted and ranked all stocks within the Russell 1000 universe according to their Profitability scores and then constructed factor-mimicking portfolios by taking the first quintile of stocks with the highest scores and weighting them equally. We rebalanced the factor strategies on a monthly basis and calculated their performance from January 1979 to June 2022. 

Historical Performance of the Profitability Factor

 Fama–French ProfitROEROICROARussell 1000
Annualized Return14.2%14.2%14.0%13.4%10.1%
Annualized Volatility17.2%17.4%17.1%17.3%15.3%
Sharpe Ratio0.580.580.570.530.39
Maximum Drawdown–53.6%–55.3%–53.0%–61.6%–51.1%
Upside Capture Ratio1.
Downside Capture Ratio1.
Source: Northern Trust Quant Research, FactSet, Russell 1000, January 1979 to June 2022

Our analysis shows all four Profitability strategies generated positive excess returns relative to the Russell 1000. But they all experienced higher maximum drawdowns than the benchmark and had a downside capture ratio over 1. As such, the Profitability strategies failed to provide downside protection. 

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The Case for Conservatism

These results demonstrate that the profit-centric view of Quality can lead to higher downside risk. Why? Because the overemphasis on Profitability encourages firms to take on excessive leverage and conduct empire-building activities, among other profit-chasing pursuits. A profitable but highly levered firm may have greater default or bankruptcy risk when financial stress increases amid economic crises. 

Minimizing such risks requires a multi-dimensional approach that incorporates Conservatism into the Quality design. We look for firms with high levels of profitability that also exhibit greater financial conservatism. That means lower leverage, stronger balance sheets, more conservative asset growth, etc. 

To illustrate the process, we examined the performance of various Profitability and Conservatism metrics during the Global Financial Crisis in 2008 and the COVID-19 crisis in 2020. The following chart shows the annualized return spreads between equally weighted top and bottom quintile factor-mimicking portfolios during the market crashes. We found that Profitability metrics generated negative return spreads. For instance, ROE, ROIC, and ROA had return spreads of –25% to –37% during the recent COVID crisis. By contrast, all Conservatism metrics had positive return spreads during both stress events.

Profitability vs. Conservatism during Crises

Note: Prudent Capex Growth prefers low CAPEX growth over high CAPEX growth.
Source: Northern Trust Quant Research, FactSet, Russell 1000

Next, we demonstrated the defensive characteristic of Conservatism with scatter plots and fitted polynomial curves for both Profitability and Profitability Plus Conservatism. The fitted curves illustrate that the convexity of Profitability improved from –0.11 to +0.04 when it was combined with Conservatism. The positive convexity, or smile effect, is the defensive feature that drives the factor’s outperformance in both up and down markets.

Convexity of Factor Returns

Note: Profitability is based on composite metrics of ROA, ROE, ROIC, and Profit. Conservatism is based on composite metrics of CAPEX growth, Leverage, and Cash Holdings.
Source: Northern Trust Quant Research, FactSet, Russell 1000

Finally, we updated the first chart by adding our Profitability Plus Conservatism portfolio. We found that the composite factor offered much better downside protection and risk-adjusted returns than the more simplistic Profitability metrics. The Profitability Plus Conservatism portfolio had a lower maximum drawdown and higher risk-adjusted returns.

The Profitability Plus Conservatism Factor

ability +
1. Composite profitability consists of equally weighted Fama–French Profit, ROE, ROIC, and ROA;
2. Profitability with Conservatism consists of equally weighted profitability metrics and conservatism metrics.
Source: Northern Trust Quant Research, FactSet 


Academic literature may treat Profitability and Quality as synonyms, but our research shows they are far from analogous. High-Profitability stocks can suffer from excessive leverage, aggressive business models, and so on. When crises come, they may not provide much of a safety net.

But Conservatism can add that extra dimension to Quality, one that can potentially deliver higher risk-adjusted returns.

Further Reading

Fama, Eugene F., and Kenneth R. French. “The Cross-Section of Expected Stock Returns. The Journal of Finance.

Novy-Marx, Robert. “The Other Side of Value: The Gross Profitability Premium.” Journal of Financial Economics.

Hsu, Jason, Vitali Kalesnik, and Engin Kose. “What Is Quality? Financial Analysts Journal.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ photonaj

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About the Author(s)
Daniel Fang, CFA

Daniel Fang, CFA, is a vice president at The Northern Trust Company, Chicago and senior quantitative research analyst responsible for quantitative equity, fixed income and multi-asset strategy research, design, and development. Fang has worked in quantitative finance since 2009 and specializes in quantitative research, portfolio management. and risk modeling. Prior to joining Northern Trust, Fang was a research analyst at Nuveen Investments where he co-managed two income funds and worked on asset valuation and asset allocation research. Prior to Nuveen, he spent four years at Allstate Investments as a quantitative researcher focused on asset allocation, derivative modelling, and risk management. Fang started his career in finance at Group One Trading, a CBOE designated option trading firm in Chicago. He has a master's degree in financial mathematics from the University of Chicago and a BA degree in hydraulic engineering from Tsinghua University, China. Fang also studied in a doctoral program in civil engineering at the Georgia Institute of Technology.

Rob Lehnherr, CFA

Rob Lehnherr, CFA, is head of quantitative equity research at Northern Trust Asset Management. He is responsible for NTAM's factor-based research and product development. Prior to joining Northern Trust, Lehnherr was a member of the asset allocation research team at Allstate Investments, LLC. He received an MBA from the University of Chicago as an Amy and Richard F. Wallman Scholar, with concentrations in analytic finance and econometrics. Lehnherr has a bachelor's degree from the University of Iowa where he studied computer science. He is a member of the CFA Society Chicago.

1 thought on “Conservatism: De-Risking the Profitability Factor”

  1. Walter Street says:

    Very interesting read, thanks for sharing!

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