(In the 4th paragraph, adds the dropped words "divided by book value" to the definition of direct profitability, and in the 5th paragraph corrects the spelling of Savina Rizova's name from Risova.)
By John Wasik
CHICAGO, Aug 27 (Reuters) - It's well known that small-company stocks have outperformed large-company stocks in terms of average annualized return since the 1920s, and bargain-priced stocks tend to outperform growth stocks.
Now there's another factor worth watching: direct profitability.
Recent research by money management firm Dimensional Fund Advisors (DFA) shows a significant premium over time for investing in companies with high direct profitability - and you can adjust your portfolio accordingly to reap those outsized gains.
DFA's definition of direct profitability is a bit technical: operating income before depreciation and amortization minus interest expense divided by book value. In non-accounting terms, companies with high direct profitability are expected to have better returns than those with lower direct profitability.
In a paper recently released by Austin, Texas-based DFA, researchers Gerard O'Reilly and Savina Rizova found that a group of high-profitability stocks outperformed a low-profitability group in terms of annualized average return by more than 5 percentage points over the period 1975-2012 - 17 percent vs. 11.7 percent.
For non-U.S. developed and emerging markets, the premiums were even greater - 5.4 percent and 6 percent, respectively.
"DFA connected the academic and practical elements into a way of making money across all markets," said Lee Munson, chief investment officer of Portfolio LLC in Santa Fe, New Mexico.
DFA, which builds portfolios based on academic research, would not name specific stocks that would merit a profitability premium, but DFA spokeswoman Faith Yando said broad diversification is essential.
"Like other premiums, such as value and small-cap, it is challenging to predict when individual companies may realize the profitability premium," she said. "We position our portfolios in a broadly diversified way, targeting stocks that exhibit characteristics that research shows have higher expected returns ... Therefore, our portfolios typically hold hundreds, if not thousands of stocks."
When it comes to profits, a good example I would offer as a bellwether stock is Johnson and Johnson. The pharmaceutical and consumer products company beat earnings estimates in the most recent quarterly report on July 16. The company is benefiting from higher profit margins and growing businesses around the world, particularly in developing countries such as China, India and Brazil.
J&J's prescription drug sales rose nearly 12 percent in the most recent quarter; medical device sales climbed nearly 10 percent. If the company can sustain profits, it's a good long-term holding. Robust profits are also fueling its healthy 3 percent dividend yield.
There's no way to predict which style or size of company will be a Wall Street darling, so the best way to cover the most ground is through a broad-based ETF or mutual fund.
The DFA U.S. Core Equity 1 fund, a low-cost broadly diversified vehicle charging 0.19 percent annually, tilts toward small and value stocks. It holds well-known companies such as Apple Inc, General Electric Co and AT&T Inc, along with lesser-known smaller companies.
Gaining nearly 27 percent over the past year through Aug. 23, the DFA fund is beating the S&P 500 index by five percentage points, and it has topped the large-stock benchmark in every year but one (2011) over the past five years.
Unlike most retail funds or ETFs, you can buy DFA funds only through brokers or advisers.
The FlexShares U.S. Market Factors Tilt ETF charges 0.27 percent annually to offer increased exposure to small- and bargain-priced companies in addition to popular stocks such as Exxon Mobil Corp, Procter & Gamble Co and J&J.
Through Aug. 23, the FlexShares fund is up 26 percent for the year, compared to 21 percent for the S&P 500 Index's total return.
Although past returns in stock prices don't always portend the future, persistent profits often predict better future performance, which is the thrust of the DFA study and a significant bonus for investors - if it holds up over time.
Don't confuse these funds with low-volatility funds, though, which dampen risk by holding well-known high-dividend stocks. Since they reflect the market as a whole with slight biases toward more volatile small-company and value stocks, they can get battered during a downturn. The DFA fund, for example, lost more than 36 percent in 2008, slightly less than the S&P 500. (Follow us @ReutersMoney or here; Editing by Lauren Young and John Wallace)