Stock market strategy: Profitability-based factor strategies consistently outperform Nifty 50: Capitalmind

Factor strategies based on profitability metrics have historically outperformed the Nifty 50 Index, a recent study by Capitalmind Financial Services has revealed. The study underscores the effectiveness of selecting stocks using profitability measures such as gross profits to assets and return on equity to build resilient and high-performing portfolios.

Factor investing, which involves selecting stocks based on characteristics like profitability, momentum, value, and low volatility, provides a systematic and data-driven approach to investing. The study demonstrates that a profitability-factor portfolio, constructed using a composite measure, significantly outperformed the Nifty 50 over the long term.

A ₹100 investment in July 2007 in the profitability-based strategy would have grown to ₹1,765 today, delivering an annualized return of 17.9%, compared to the Nifty 50’s ₹810 with a 12.8% annualized return.

Consistent Outperformance Over Rolling Periods

The Capitalmind study found that the profitability strategy outperformed the Nifty 50 in 86% of 5-year rolling periods, with a median annualized return of 17.5%, compared to the Nifty’s 13.1%. Even in shorter durations, such as 3-year rolling periods, the profitability strategy demonstrated an 80% success rate against the benchmark.

The study also highlighted that over 1-year rolling periods, profitability-based strategies outperformed the Nifty 50 two-thirds of the time, showcasing their resilience across market conditions.

Risk-Adjusted Returns and Stability

Beyond raw performance, the study found that profitability strategies offer superior risk-adjusted returns. The profitability factor strategy experienced smaller drawdowns and faster recoveries compared to the Nifty 50. During the 2008 Global Financial Crisis, the Nifty 50 saw a -60% drawdown, whereas the profitability-based strategy limited losses to -51% and rebounded more quickly.

Moreover, the study revealed that the profitability strategy recorded a 44% higher Sharpe ratio and 42% higher Sortino ratio than the Nifty 50, indicating that investors received higher returns with lower volatility.

Challenges and the Case for Multi-Factor Investing

While profitability-based strategies have demonstrated long-term success, recent high valuations have led to more subdued performance. Capitalmind’s study suggests integrating profitability with other factors like momentum and low volatility to mitigate factor-specific performance cycles.

Divyansh Agnani, Research Analyst at Capitalmind Financial Services, pointed out, “Globally, profitability factor investing has been widely adopted, but the factor investing landscape in India has yet to tap its potential. Of the ₹30,778 crore invested in style-based passive mutual funds, only ₹1,817 crore is allocated to Profitability or Quality styled funds. This is a curious disconnect, given the demand for Quality funds in the active funds category. Our analysis suggests that high valuations, which active fund managers have the flexibility to counteract, may be a key factor.”

Future Outlook for Factor Investing in India

As Indian markets mature, factor-driven investing is expected to gain further acceptance among investors. Capitalmind’s study advocates for a structured approach to investing, where profitability strategies are combined with other factors to reduce cyclicality and enhance long-term stability.

With data-backed investing gaining momentum, Indian investors are encouraged to explore profitability strategies alongside other factor-based models. This approach can help build a resilient and high-growth portfolio, ensuring more stable and predictable returns in the long run.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.