In this episode of \"What's the Risk,\" we take a look at the Fama French US High Profitability Research Index. While the original Fama-French model focused on three factors, this index emerged from their 2015 research update which expanded the framework to five factors. Fama and French identified that stocks with higher operating profitability have historically delivered higher expected returns that were not fully explained by market, size, or price-to-book metrics alone.
Fama and French define this profitability by looking at a firm's operating income. Specifically, they calculate it by taking total revenue and subtracting the cost of goods sold, selling, general and administrative expenses, and interest expense, then dividing that figure by book equity. This process allows the index to filter for firms with \"robust\" internal earnings power, distinguishing them from \"weak\" firms that struggle to generate the same level of efficiency. By focusing on these high-margin businesses, the index seeks to isolate a specific dimension of stock returns that has persisted across different eras and markets.
While the Fama French US High Profitability Research Index is not an investible index, the research by Fama and French continues to inform the methodology of Dimensional Fund Advisors, where Fama and French serve as board members.
Want to learn more about investing? Search for \"Your Investment Philosophy\" on Amazon, Australian link: https://www.amazon.com.au/Your-Investment-Philosophy-Protecting-Fraudsters-ebook/dp/B0BCPJ8BGC/
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