Time to Add Profitability to Portfolios: Eric Nelson

"Market" naturally also benefited from profitability, with portfolio gains of 1% and 1.9% for large and small stocks, and a reduction of risk by 0.2 and 1.3% respectively.

The Oklahoma City-based wealth manager cautions that all these results are based on back-testing, and we cannot know if they will be repeated in the future, and further that it is not completely clear as yet that profitability is the sole determinant of these results—something future regression analyses might reveal.

But Nelson tells ThinkAdvisor that future results for the profitability factor depend on the true source of its return enhancement:

"As of now, the evidence is quite mixed on whether returns from highly profitable stocks are risk-based or behavioral. If it's based on risk, then we'd expect it to persist as the … small cap and value premiums have. If it's behavioral, [investors] may 'wise up' and the premium will disappear, or we could continue to make the same mistakes—undervaluing the most profitable companies—and the premium will persist."

Despite uncertainty about the source of return enhancement, Nelson is still a fan of the stocks of profitable companies.

"Even if the profitability premium is smaller or goes away in the future, it may still be worthwhile to target, as profit and value tend to move opposite each other, giving rise to a diversification benefit—as witnessed by higher returns and lower risk in the data," he says.

If the factor proves to be lasting, Nelson offers a valuable insight: that investors can lower portfolio risk through the addition of return-enhancing stocks, something traditionally done through the inclusion of bonds which lower risk but which dilute expected portfolio returns.

While higher returns and lower risk in theory suggests that advisors can rev up their portfolios with stock-only allocations, Nelson hasn't changed his own clients' bond allocations.

The Servo advisor neutralizes bonds' tax consequences through "asset location," that is keeping bonds mainly in clients' tax-protected IRA accounts.

"I'm mainly looking at it as a potential boost‎ to our stock allocations—higher overall returns with a slightly smoother ride and without as much of the abrupt underperformance when value/small underperform—profitability inclusion helps dilute that somewhat," he says.

In a nutshell, he adds, including profitability in clients' portfolios makes "the pre-retiree or retiree's job just a little easier … which is always a good thing!"