Why Profitable Companies Beat "Growth" Stocks

#The Growth Trap

Every era has its darlings. In the late 1990s, it was dot-coms. In 2020-2021, it was money-losing "disruptors."

The story is always the same: "Profits don't matter—only growth matters."

The ending is always the same too.

Here's what 50+ years of academic research tells us: profitability predicts returns; growth without profits doesn't.

#The Academic Evidence

Ball et al. (2016): Cash-Based Operating Profitability

Robert Ball and colleagues published a landmark study in the Journal of Financial Economics showing that cash-based operating profitability—not accounting earnings—best predicts stock returns.

Their key insight: Companies can manipulate accounting earnings through accruals. Cash flows are harder to fake.

Formula: `` Cash-Based Operating Profit = Operating Profit − Changes in Working Capital ÷ Average Assets ``

Companies with high cash-based profitability outperformed those with low profitability by approximately 4% annually.

Novy-Marx (2013): Gross Profitability

Robert Novy-Marx at the University of Rochester found that gross profitability (revenue minus cost of goods sold, divided by assets) predicts returns as well as book-to-market value.

He called profitability "the other side of value." Value and profitability work for different reasons but complement each other.

Asness et al. (2019): Quality Minus Junk

AQR's Cliff Asness and team created a comprehensive "quality" factor combining: - Profitability - Growth stability - Safety (low leverage, low volatility) - Payout (returns cash to shareholders)

Their "Quality Minus Junk" factor has positive returns in every decade since 1957.

#Why Profitability Works

1. Profitable Companies Survive

Unprofitable companies dilute shareholders to fund operations. They take on debt. They eventually fail or get acquired at distressed prices.

Profitable companies generate cash, buy back shares, pay dividends, and reinvest at high returns.

2. The Market Underestimates Persistence

Investors assume high profitability is temporary—that competition will erode margins. Research shows profitability is more persistent than expected. Today's profitable companies tend to remain profitable.

3. Glamour Stocks Get Overpriced

Exciting, fast-growing companies attract attention and capital. This bids up prices beyond reasonable levels. When growth disappoints—as it usually does—prices crash.

Boring profitable companies fly under the radar and remain undervalued.

#Quality Across Market Conditions

One remarkable feature of the profitability factor: it works in all market regimes.

This is why we weight profitability at 30%—the highest of any factor in our model.

#Case Study: 2020-2022

The COVID period provided a perfect natural experiment:

2020-2021: Unprofitable "innovation" stocks soared. Tesla, Zoom, Peloton, and countless SPACs reached astronomical valuations.

2022: Reality returned. The ARK Innovation ETF fell 67%. Many SPACs dropped 80%+. Unprofitable companies were decimated.

Profitable companies? They held up. Companies with strong cash flows—often dismissed as "boring"—preserved capital while speculators suffered.

This wasn't anomalous. It was the profitability factor doing exactly what 50 years of research predicted.

#How We Measure Profitability

Following Ball et al. (2016), we calculate cash-based operating profitability:

1. 1Start with operating income (revenue minus operating costs)
2. 2Adjust for accruals (subtract working capital changes)
3. 3Scale by average assets (for comparability across company sizes)
4. 4Winsorize at 1%/99% (limit outlier influence)
5. 5Convert to z-score (standardize for combination with other factors)

This gives us a clean, manipulation-resistant measure of true profitability.

#The Bottom Line

The next time someone tells you "profits don't matter," remember:

• 50+ years of academic research says otherwise
• Every stock bubble ends the same way
• Profitable companies win over full market cycles

Quality isn't exciting. It doesn't make headlines. But it works.

See highest-profitability stocks →

#Academic Sources

• Ball, R., Gerakos, J., Linnainmaa, J. T., & Nikolaev, V. (2016). "Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns." Journal of Financial Economics

• Novy-Marx, R. (2013). "The Other Side of Value: The Gross Profitability Premium." Journal of Financial Economics

• Asness, C. S., Frazzini, A., & Pedersen, L. H. (2019). "Quality Minus Junk." Review of Accounting Studies