Episode 384: Mamdouh Medhat - A Profitability Retrospective, and Private Fund Performance

What It Covers

Mamdouh Medhat from Dimensional Fund Advisors examines profitability's role in factor investing, revealing how it explains quality metrics and defensive strategies, plus analyzes private fund performance against style-appropriate public market benchmarks using specialized methodologies.

Key Questions Answered

• •Profitability subsumes quality: Operating profitability (revenues minus COGS, SG&A, and interest expense, scaled by book equity) explains returns of all 15 quality metrics tested, including complex composites like QMJ's 28 signals. Quality metrics produce no alpha beyond profitability, but profitability adds value beyond quality.
• •Defensive equity explained: High profitability stocks are the strongest predictor of low volatility characteristics. An 80/20 portfolio combining high profitability, low investment stocks with T-bills outperforms long-only defensive equity strategies while maintaining lower equity exposure and producing zero five-factor alpha for standard defensive portfolios.
• •Value underperformance decoded: Approximately half of value's US underperformance since 2007 stems from its negative correlation with profitability during profitability's strong outperformance period. The remainder relates to industry tilts. Controlling for profitability exposure and constraining industry bets produces small positive returns versus large negative unadjusted returns.
• •Private market reality check: Average buyout and VC funds perform in line with small cap value or high profitability small cap growth benchmarks using Kaplan-Schoar PME methodology, not above S&P 500. Private credit matches high yield bonds. Post-2007 fair value accounting reveals 70-80% of private fund returns explained by public market factors.
• •Country tilts ineffective: Sorting countries or industries on aggregate characteristics like valuation, size, or profitability produces weak, unreliable return spreads with no alpha beyond security-level factor exposures. Security-level tilting within countries held at market weight provides superior diversification and flexibility for capturing premiums efficiently.