Profitability, Investment, and Quality Factors

While momentum is not part of the Fama-French Five-Factor Model, the 2015 extension introduced two new factors, profitability and investment, that capture aspects of what practitioners often call "quality" investing.

The Profitability Factor (RMW)

The profitability factor is based on the intuition that, all else equal, companies with higher profitability should have higher expected returns. This seems almost tautological, but the key insight is that the relationship holds even after controlling for valuation (book-to-market ratio).

Key Finding: Among stocks with similar valuations, those with higher operating profitability tend to outperform. This suggests profitability contains information about expected returns beyond what's captured by price multiples.

Fama and French measure operating profitability as:

Operating Profitability = (Revenue - COGS - SG&A - Interest Expense) / Book Equity

The Investment Factor (CMA)

The investment factor captures the "asset growth anomaly" - the finding that companies growing their asset base rapidly tend to subsequently underperform companies investing more conservatively.

Several explanations have been proposed for this pattern:

Overinvestment: Managers of firms with easy access to capital may overinvest in negative NPV projects, destroying shareholder value.
Market Timing: Companies tend to raise capital and invest when their stock is overvalued, leading to subsequent underperformance.
Limits to Growth: Rapid asset growth may reflect companies approaching the limits of profitable opportunities in their industry.

Quality as an Investment Style

Many practitioners combine profitability and investment factors into a broader "quality" style. Quality strategies typically favor companies with:

High and stable profitability
Low leverage (debt-to-equity)
Consistent earnings growth
High return on equity
Strong cash flow generation
Conservative accounting practices

The Momentum Factor

Although not included in the Fama-French Five-Factor Model, momentum is another well-documented factor. First systematically studied by Jegadeesh and Titman (1993), momentum refers to the tendency of stocks that have performed well recently to continue performing well in the near term.

The Carhart Four-Factor Model adds momentum (often called MOM or UMD for "Up Minus Down") to the original Fama-French Three-Factor Model. Many practitioners use both Fama-French factors and momentum in their analysis.

Novy-Marx, R. (2013). "The other side of value: The gross profitability premium." Journal of Financial Economics, 108(1), 1-28.