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Profitability and Investment Premia: What Fama–French’s ‘Quality’ Factors Mean for Investors
The Capital Asset Pricing Model (CAPM) assumes that a stock’s expected return is explained entirely by its sensitivity to the market portfolio: one factor, one beta. Yet in practice, the CAPM leaves much unexplained. Fama and French (1993) formalised these findings in their three-factor model, adding size (SMB) and value (HML) to the market factor.
Even then, further anomalies persisted. Portfolios sorted by profitability and investment intensity were not explained by the three-factor model. Fama and French (2015) expanded the framework to five factors, adding profitability (RMW—robust minus weak) and investment (CMA—conservative minus aggressive). This version explains the cross-section of returns more effectively, showing that much of what was previously attributed to value is better captured by profitability and investment.
For investors, RMW rewards exposure to firms with sustainable earnings, whilst CMA rewards avoiding those that pursue growth too aggressively. Profitability has been a consistent and defensive premium; investment more cyclical but valuable in filtering out overpriced growth.
The Size Premium Myth? Why Small May Need Friends
The so-called ‘size premium’—the idea that small companies reliably beat large ones, has always sounded intuitive. Smaller firms are riskier, less liquid, and harder to hold, so they should deliver higher returns. Yet the evidence is far from clear. Long-term data show bursts of small-cap outperformance, but these gains are patchy, fragile, and often vanish once you adjust for higher market betas. What really drives results is the company type: small-cap value and high-quality firms have consistently delivered, whilst small-cap growth has been persistently weak. The charts in this post make it plain—size on its own is not a premium, but paired with value and profitability it remains a powerful portfolio building block.
Are US Equities in a Bubble? Or Just Priced for a Different World?
Whenever the S&P 500 makes new highs, ‘bubble’ talk returns. Valuations are undeniably rich—CAPE in the high 30s and forward P/Es above long-run norms, but ‘high’ is not the same as ‘irrational’. A lower and more stable inflation/real-rate backdrop, an economy heavier in intangibles, accounting changes, curated index construction, and easier market access can all support a higher equilibrium multiple than in earlier decades. The takeaway is that from rich starting points, long-run returns tend to be lower.
Understanding Key Financial Ratios in Modern Portfolio Theory
Investing is about more than just chasing returns—it’s about understanding the risks that you’re taking to get them. Financial ratios grounded in Modern Portfolio Theory (MPT) help investors evaluate performance in a structured way, accounting for both total volatility and market sensitivity.
From standard deviation and beta—which capture different types of risk—to the Sharpe ratio, alpha, and the information ratio—which assess how efficiently returns are earned—these metrics offer powerful insights into the true quality of an investment.
Used together, they don’t just measure performance, they help investors make better, more informed decisions.
Good financial decisions aren’t about predicting the future—they’re about following a sound process today.
In investing, outcomes are noisy. Short-term performance often reflects randomness, not skill. Yet fund managers continue to pitch five-year track records as if they prove anything. They don’t.
As Ken French puts it, a five-year chart ‘tells you nothing’. The real skill lies in filtering out the noise—evaluating strategy, incentives, costs, and behavioural fit.
Don’t chase what worked recently. Stick with what works reliably.