DOES IT STILL PAY TO BE PROFITABLE? NOT AS MUCH RECENTLY

INVESTING INSIGHTS DOES IT STILL PAY TO BE PROFITABLE? NOT AS MUCH RECENTLY Historically, profitable companies have been correlated with higher expected returns for investors, but the last five years have seen this trend weaken. Of late, investors have allocated significant amounts of capital not to the most profitable companies in a given sector but to the largest. The FAANGs Facebook, Amazon, Apple, Netflix, and Google are famous examples of this. In the current environment, the biggest companies are not generally the most profitable examples of their industries, and more-profitable investment opportunities can be found in smaller-cap companies. Ultimately, we don t believe that this trend is likely to be permanent, and it is a good idea for investors to look to avoid following the herd into higher- and higher-priced securities and sectors. It s as obvious an investment principle as you can find: Profitable companies, if they re selling at fair prices, should offer investors better returns than their less-profitable counterparts. Historically, this has been the case: More-profitable companies have been associated with higher stock returns across decades of data. The relationship between profitability and stock performance has been well documented by the team of Eugene Fama and Kenneth French, by Robert Novy-Marx, and other eminent researchers. 1 A company s profitability can be a powerful measure of expected performance, especially among Growth stocks (which most highly-profitable companies are), in the same way as the price/book ratio is in the Value universe. Indeed, we found that over the last 5 years, the stocks of the most-profitable US companies earned about a three-percentage-point annualized premium over their least-profitable counterparts, and a one-point premium over the S&P 5 not in every market environment along the way, but over the long term. However, the apparent attractiveness of this investment factor has been turned on its head of late (Exhibit 1): For roughly the last five years within the larger 5-year period, investors have poured in more funds to less-profitable companies, expanding their market capitalizations and spurring superior stock performance. And this trend is observable not only in the US but globally, although our focus in this paper is on the US market. What Happened? Although no return premium is assured in the short run, a pattern of extra return for highly-profitable companies has been consistently observed over the long-term. So we wanted to investigate why the pattern has been broken over the last five years: What market trends might help 1 See Eugene F. Fama and Kenneth R. French, A Five-Factor Asset Pricing Model, Journal of Financial Economics, Vol. 116, Issue 1 (April 15) and Robert Novy-Marx, The Other Side of Value: The Gross Profitability Premium, Journal of Financial Economics, Vol. 18, Issue 1 (April 13). For the purposes of this paper, we are defining profitability as either gross profits, measured relative to the market capitalization or other characteristics of a company, or as an equal-weighted measure of asset turnover, gross Investment Products & Services Not insured by FDIC or any Federal Government Agency May Lose Value Not a Deposit or Guaranteed by a Bank or any Bank Affiliate Gerstein Fisher is a division of People s Securities, Inc., a Broker/Dealer, member of FINRA and SIPC, and a registered investment advisor. People s Securities, Inc. is a subsidiary of People s United Bank, N.A. For Current and Prospective Client Use

Exhibit 1: Annualized Return Comparison S&P 5, High-Profitability Stocks and Low-Profitability Stocks Jan. 1, 1967 Oct. 31, 17 % 18 16 1 1 1 8 6 11.35% 1.33% 8.38% 15.9% 15.77% 1.77% Jan. 1, 1967 Oct. 31, 17 Jan. 1, 1 Oct. 31, 17 Most-Profitable US Stocks S&P 5 Least-Profitable US Stocks Notes: The Most- and Least-Profitable US-stock universes are defined as firms above the median market-capitalization breakpoint for all US equities traded on the NYSE with the highest 3% and lowest 3% operating profitability, respectively. Sources: Gerstein Fisher Research and Standard & Poor s, http://mba.tuck. dartmouth.edu/pages/faculty/ken.french/data_library.html explain the divergence from history? Does the attention currently being paid to the least-profitable companies signal a secular change in investor behavior or are we seeing a temporary blip on the screen? We begin by making the following observations: Investors have been unusually complacent about (or perhaps comfortable) with risk over the last few years notwithstanding economic uncertainty around the world and geopolitical tensions. The VIX index, used as a touchstone for volatility in the US stock market, has been hovering near historical lows. We re in a period where investors are more willing than usual to take on extra risks and so more capital is being allocated to companies with low profitability (or no profitability at all). As a result, some stock prices have risen significantly when compared to company fundamentals, including profitability, at least by historical measures. This is reminiscent of the tech bubble in the late 199s, and in fact, the tech sector is once again front and center. It is possible we are seeing a familiar cycle playing out, where higher stock prices are encouraging more investors to buy, which leads to yet higher prices. As Warren Buffett wrote to his shareholders in, Nothing sedates rationality like large doses of effortless money. 3 The popularity of indexing today abets this problem. By definition, indexed portfolios emphasize the most richly priced stocks in the market, which leaves index investors with ever-higher allocations to expensive stocks. We re not predicting a market crash, like the one that followed the collapse of the tech bubble. But based on research, data, and the fundamental logic that profitable companies should be more rewarding to investors, we do expect that over time the return premium of more profitable companies will return. There s a Lot of Information in a Price In investment environments like today s, when investors seem very comfortable with taking risk and buying high-valuation securities, we re especially careful in our portfolio strategy decisions. Not overpaying for investment assets is even more important right now than usual, whether price is compared with revenues, earnings, sales, or other measures: In our view, price is the numerator in the most critical ratios for investment managers, particularly today. The FAANGs Facebook, Amazon, Apple, Netflix, and Google (trading as Alphabet, its parent company), now sitting on top of the world, are dynamic and wildly successful companies (although not all of them are wildly profitable). But of these five companies, only Apple has a market cap well-aligned with its profitability. The others are significantly bigger than their profits would suggest compared with their sector peers (Exhibit ). As of December 11, 17, Amazon, for instance, sported a trailing price-to-earnings ratio of 98! For us, this is a yellow light: We re not shunning the FAANGs in our portfolios, but we re being conservative in sizing their positions. Exhibit : Sector-Weighted italization and Gross Profitability Data as of Dec. 11, 17 Company (Bil.) Profitability Facebook* $5.1 9.% 3.8% Amazon $559.9 1.6%.8% Apple $869.6 15.5% 1.% Netflix $81.6 1.8%.3% Google $7.8 1.9% 8.8% Sources: Gerstein Fisher Research and Bloomberg * Class A shares 3 Letter to Berkshire Hathaway shareholders

Exhibit 3: Netflix italization vs. Profitability Dec. 31, 1 Oct. 31, 17 italization ($ Billions) 9 8 7 6 5 3 1 Dec-1 Aug-13 Apr-1 Dec-1 Aug-15 Apr-16 Dec-16 Aug-17. 1.8 1.6 1. 1. 1..8.6... Exhibit : Barnes & Noble italization vs. Profitability Dec. 31, 1 Oct. 31, 17 italization ($ Millions), 1,8 1,6 1, 1, 1, 8 6 Dec-1 Aug-13 Apr-1 Dec-1 Aug-15 Apr-16 Dec-16 Aug-17. 1.8 1.6 1. 1. 1..8.6... Sources: Gerstein Fisher Research and Morgan Stanley Capital International (MSCI) Or consider the comparison of two companies: Netflix vs. Barnes & Noble. Netflix is a market darling these days, while Barnes & Noble is an unloved company in an unloved industry (the stock was down considerably in 17). True, the company is generating only half the profits of Netflix, and one-third of its revenue but it s times smaller: Its profits are worth far more than Netflix s, dollar for dollar, relative to its market cap. Netflix may continue to post superior returns going forward, but empirical asset-pricing theory suggests that a basket of stocks similar to Barnes & Noble should have a higher expected return looking forward. In fact, if we look at the trend since the end of 1, we see that while Netflix has enjoyed explosive growth in market capitalization, its profitability has been stable at best (Exhibit 3). For Barnes & Noble, the trend has been the opposite for Value investors, even better than strictly opposite: The company s profitability is rising even as its market cap has fallen by roughly half (Exhibit ). In general, we seek out companies for our portfolios whose profit contributions to their sectors are in line with, or above, their market-cap contributions. Consider the select representative holdings in Exhibit 5 (a group of companies which posted returns of between % and 75% in 17 through mid-december): In each case, the company s ratio of size to profitability was appropriate, suggesting the potential for good stock returns ahead. Also note that several of the companies shown in Exhibit 5 are smaller-cap and are, broadly speaking, firms with valuations that have not increased as dramatically as they have for the FAANGs described earlier. Exhibit 5: Select Company Comparison vs. Sectors italization and Profitability Data as of Dec. 11, 17 Company (Bil.) Profitability Big Lots $.5.1%.% Groupon $3..1%.% Intel $.9 3.6% 5.8% Skechers USA $5.7.1%.% Wal-Mart Stores $86. 6.% 1.5% Sources: Gerstein Fisher Research and Bloomberg Profitability Tilts Toward Smaller-Cap If the market s skew toward less-profitable companies is one notable trend today, and the rising valuation of certain key companies is another, there s a third piece of the puzzle: a shift in (relative) profitability toward smaller-cap companies. Historically, the most-profitable companies were, on average, also the largest companies in their sectors. No more: At least in the current market, the size of the most-profitable US companies is now almost tied with the size of the least profitable. The historical profitability gap as measured by market cap has virtually disappeared. 3

Exhibit 6: Average of US Equities by Profitability Dec. 31, 1995 Nov. 3, 17 Exhibit 7: Average of US-Technology-Sector Equities by Profitability Dec. 31, 1995 Nov. 3, 17 1 1 Most-Profitable Companies Average-Profitability Companies Least-Profitable Companies 3 5 Most-Profitable Companies Average-Profitability Companies Least-Profitable Companies 1 $ Billions 8 6 $ Billions 15 1 5 Dec-95 Aug-98 Apr-1 Dec-3 Aug-6 Apr-9 Dec-11 Aug-1 Apr-17 Dec-95 Aug-98 Apr-1 Dec-3 Aug-6 Apr-9 Dec-11 Aug-1 Apr-17 Exhibit 6 shows this by dividing the universe of US companies into terciles of profitability, and comparing those terciles with their average market caps, from the end of 1995 through November 17. Until around 1, the most profitable were almost consistently large and even after the correlation began changing, it took until 17 for the terciles to be almost evenly distributed by market cap. (Of course, the relationship isn t perfect: Some highly-profitable companies remain large- and mega-cap.) The tech sector looks like a turbocharged version of the total market (Exhibit 7), with years -long domination of profitability by the largest-cap companies giving way to a spike in market cap among companies in the second tercile of profitability and then a sharp rise in the capitalization of the least profitable. With the tech sector once again undergoing radical transformation marked by rapid developments in mobile technology, artificial intelligence, and other areas of inquiry investors have been willing to allocate more capital to technology-oriented businesses. This has pumped up both their size and their stock returns. And these allocations by investors have often been made without their usual attention to company profitability. It remains to be seen where this trend goes, but in the interim we re balancing tech weightings in our portfolios with broad-based and diversifying exposure to other sectors. Our goal remains what it always has been: seeking to avoid the excesses of various market trends while maintaining a quantitative, disciplined focus on seeking tilts to value-oriented and other risk factors that should offer higher risk-adjusted returns. One caveat: Not every sector has experienced the pattern in the broad market. Among consumer-discretionary companies, for example, both in the US and globally, the biggest have typically been the least profitable over the last years or more. This is probably traceable to the slow-growth businesses that are so prevalent in consumer-oriented industries. However, the most-profitable US group in the sector did spike up in cap size beginning in 15, as the decline of low-margin brick-and-mortar retailers accelerated. The Very Largest Companies Tend to Lag in Profitability Having said all this, we need to make clear that across the market, the very largest companies, at least in the current period, have been relatively less profitable than peers in their sectors (Exhibit 8). We d also observe that as the market has risen over the last five years, growth in profitability has not kept pace. The ratios of market cap to profitability have expanded over the past five years in all sectors a signal, as indicated above, that in many cases company market caps may be misaligned with their profitability, or at the very least that investors (on average) are increasingly comfortable with owning less-profitable companies. In the energy sector the ratio has expanded most dramatically from about $5 of market cap per $1 of profit five years ago to an 11.5:1 ratio today, with an even bigger jump among the five largest companies in the sector. Technology stocks also saw a dramatic rise in their market-value-to-profit ratios: The biggest five companies in

Exhibit 8: Ratios by Sector of to Profitability Data as of Dec. 11, 17 Current Ratio of to Gross Profits Five Largest Companies Ratio of to Gross Profits Full Sector Consumer Discretionary 6.9.69 Consumer Staples.8.9 Energy. 11.9 Health Care 6.1 6.17 Industrials 9.97 7.1 Information Technology 11.57 9.15 Materials 7.53 6.5 Five Years Ago Ratio of to Gross Profits Five Largest Companies Ratio of to Gross Profits Full Sector Consumer Discretionary 3.9 3. Consumer Staples 3.8 3.1 Energy 5.71.96 Health Care 3.6 3. Industrials 3.89 3.9 Information Technology 6.76 5. Materials 5.56 3.87 Sources: Gerstein Fisher Research and Bloomberg that sector grew from roughly $7 of capitalization per dollar of profit to almost $1. While each sector experienced this trend to a different degree, none was immune. Historically, in most sectors some key companies have had somewhat larger ratios of market cap relative to profitability, but the recent growth of the mega-caps has exacerbated this trend. This is true to a lesser extent for the sectors as whole over the last five years, and as we ll discuss in the next section, true small-cap companies have offered some more-significant premiums for profitability. A Temporary Phenomenon Or a Permanent Shift? While the largest of large companies have been (relatively) less profitable, smaller-cap stocks have not experienced the same degree of market-cap expansion as larger-cap stocks, or the same loss of the profitability premium. As investors, we are always focused on not neglecting smaller-cap companies and maintaining a wide opportunity set for investment; that is particularly the case today. In our portfolios, we are keen to remember that no hot sector or market segment grows forever, and this includes the FAANGs of today, just as dot-com companies were market darlings years ago. Investors should always be wary of over-allocating to companies after they ve seen years of exceptional returns. So we re careful about our allocations in capitalization just as in asset class, sector, and industry. And while a strategy that emphasizes profitability is currently challenging when reviewed solely with a focus on short-term trailing returns, we bear in mind that most of the time investors have been well-rewarded for buying high profits especially in the small-cap space (Exhibit 9). Smaller-cap stocks have historically been the most sensitive to company profitability, at least in the last years. In all our multi-factor strategies, our research is based on finding quantitative premiums and identifying the market segments where those premiums are the largest. Put simply, we want to cast a wide net: to buy profits and the market segments where those profits are rewarded most handsomely. Small-cap is such a market segment but even so, we don t want to put all our eggs in that basket. It s too risky, especially in light of today s skew in profitability toward small-cap, and the potential for either relative or absolute under-performance due to trying to time the market s trends either in favor of big companies, profitable companies, or any other specific market sector. 5

Exhibit 9: Profitability Return Comparison Large- vs. Small-Cap Dec. 31, 1995 Sep. 3, 17 Annualized Return Large-Cap High Profitability 9.56% Large-Cap Moderate Profitability 9.8% Large-Cap Low Profitability 7.97% Large-Cap Profitability Premium (High vs. Low) 1.59% Small-Cap High Profitability 11.5% Small-Cap Moderate Profitability 9.% Small-Cap Low Profitability.6% Small-Cap Profitability Premium (High vs. Low) 6.9% High, Moderate, and Low Profitability are defined by tercile breakpoints of profitability as calculated by an equal-weighted measure of asset turnover, gross profitability, gross profit margin, and return on assets. Large- and Small-Cap universes are defined as securities with market capitalizations of greater than $1 billion, and between $ million and $ billion, respectively. Market Trends Rarely Last Forever Unusual market environments come and go at Gerstein Fisher we ve seen two major corrections and recoveries in just the last 15 or so years but they don t change the central principles of investing. Over time, investors will demand more return for assuming more risk, and company fundamentals prove the most significant determinant of long-run stock returns across a diversified portfolio. With that in mind, we believe that investor behavior regarding a preference for reasonably-priced profitability will have an impact on the markets. We don t know how much time it will take, or what the catalyst will be for the change back to normal, but we re confident that high profitability will be rewarded by investors once again. As Novy-Marx highlighted in his seminal research, profitability and valuation factors are complementary and hence, in combination, can enhance returns meaningfully. He asserted (confirmed by our own research and experience) that a strategy focused on tilting toward stocks with exposure to a range of risk factors, including high profitability and value rankings, should generate a meaningful return premium over a benchmark universe. This concept is the basis of our Multi-Factor strategies. Conclusion A study of company profitability reveals anomalies in the current market, which is skewed toward rewarding very large companies with moderate-to-low profitability relative to their size a likely unsustainable trend in the long term. The pendulum will likely swing away from this unusual relationship between investor capital and profitability, though exactly when cannot be accurately forecasted. In short, our approach is to manage a disciplined, diversified portfolio while being mindful of security pricing and the premiums available to a Multi-Factor strategy based on the best available research. We are confident that this represents the best approach going forward for investors. Robert Novy-Marx, The Other Side of Value: The Gross Profitability Premium, Journal of Financial Economics, Vol. 18, Issue 1 (April 13). His research study covered the period July 1963 through December 1, with a universe comprising the 5 largest US non-financial companies for which the gross-profits-to-assets and book-to-market ratios were available. This is a publication of People s Securities, Inc. doing business as Gerstein Fisher. Economic and market views and forecasts reflect Gerstein Fisher s judgment as of the date of this presentation and are subject to change without notice. Views and forecasts are estimated based on assumptions, and may change materially as economic and market conditions change. Gerstein Fisher has no obligation to provide updates or changes to these views and forecasts. Certain information contained herein has been obtained from third parties. 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