5 Hugely Profitable Stocks You Haven't Heard Of

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Over the past decade Wall Street has become obsessed with factors. Every few years a new one arrives with a glossy white paper and a clever marketing pitch. Quality stocks. Defensive equities. Low volatility portfolios. Betting against beta. Earnings quality. Financial strength. Intangible-adjusted value. If you believe the marketing materials, each of these strategies represents a new and independent source of market-beating returns.

The problem is that the financial industry has a habit of rediscovering the same ideas under different labels.

A recent research paper from Robert Novy-Marx and Mamdouh Medhat titled Profitability Retrospective: What Have We Learned? takes a hard look at many of these fashionable strategies and reaches a surprisingly simple conclusion. Much of what investors think of as new factors are really just indirect ways of buying profitable companies.

Strip away the branding and complexity and a large part of the modern factor universe reduces to one central idea.

Profitability.

Novy-Marx has been studying profitability for more than a decade. His earlier research showed that firms with high operating profits relative to their assets tended to earn higher stock returns going forward. That finding was strong enough that Fama and French eventually incorporated profitability into their five-factor asset pricing model.

The new paper pushes the idea much further. Instead of simply showing that profitability works, the authors demonstrate that profitability explains the performance of several investment styles that are widely treated as independent factors.

The first of these is the entire “quality investing” category.

Quality investing has become one of the hottest themes in asset management. Fund companies now market dozens of quality ETFs and institutional strategies built around the concept. Yet if you ask ten managers to define quality, you will probably get ten different answers. Some define it as high return on equity. Others emphasize stable earnings, low leverage, strong balance sheets, or some composite score combining all of the above.

The lack of a consistent definition is not an accident. Quality is a marketing label more than a precise investment concept.

When Novy-Marx and Medhat examine the major quality metrics used in both academia and industry, they find that nearly all of them share a common feature. They tilt portfolios toward companies that are already profitable.

High return on equity companies are profitable. Firms with stable earnings are profitable. Companies with strong margins and healthy balance sheets are usually profitable as well. Even composite quality scores tend to overweight businesses with strong operating profitability.

Once profitability is included directly in the asset pricing model, the supposed alpha from quality strategies disappears. The returns are fully explained by exposure to profitable companies.

In other words, quality investing is largely a roundabout way of buying profitability.

The same pattern shows up when the authors examine defensive equity strategies.

For decades researchers have documented what appears to be a puzzling anomaly in financial markets. Stocks with lower risk, measured by beta or volatility, have often delivered higher risk-adjusted returns than riskier stocks. This observation has fueled a large literature and helped create an entire industry around low volatility and low beta investment products.

Institutional investors love these strategies because they appear to provide equity exposure with less downside risk.

But once again profitability provides the missing piece of the puzzle.

Low volatility stocks tend to be large, stable companies with steady earnings and disciplined management. Those characteristics are closely associated with profitability. Companies that generate consistent operating profits tend to have less volatile stock prices and lower market betas.

When the authors adjust for profitability and investment behavior, the apparent low risk anomaly largely disappears. Low beta and low volatility portfolios earn their returns not because low risk is magically rewarded in the market, but because those portfolios are filled with profitable companies that invest conservatively.

The profitability factor captures this effect directly.

Even some of the more sophisticated factor strategies suffer from the same problem. The widely cited “quality minus junk” factor, often abbreviated as QMJ, combines several signals including profitability, growth, safety, and earnings stability. It looks powerful in backtests and has become a staple of many quantitative strategies.

Yet when the authors regress QMJ against profitability, the results are revealing. The returns of the quality minus junk factor can be almost entirely explained by its exposure to profitability and earnings surprises. The factor itself adds little independent information.

What looks like a new source of alpha is simply another way of loading up on profitable firms.

This pattern repeats again and again across the factor landscape. Many anomalies that appear unrelated at first glance turn out to share a common economic driver. Investors keep rediscovering profitability in different disguises.

One reason profitability is so powerful is that it captures something fundamental about the economics of businesses.

A company that generates strong operating profits relative to the capital invested in the business is demonstrating an ability to create value. Profitable firms tend to have competitive advantages, disciplined management teams, and business models that produce cash rather than consume it. Those characteristics translate into stronger long-term performance.

By contrast, companies that struggle to earn profits often depend on continual capital raising, aggressive expansion, or optimistic future projections to justify their valuations. Those businesses tend to be more fragile and more sensitive to economic shocks.

When investors construct portfolios based on signals like quality, low volatility, or defensive characteristics, they often end up separating profitable businesses from unprofitable ones without realizing it. The strategies work not because the signals themselves are magical, but because they identify firms with strong underlying economics.

Profitability captures that idea directly.

The authors also show that profitability has remarkable explanatory power across international markets. Defensive equity strategies that appear to generate abnormal returns in developed markets lose their alpha once profitability and investment factors are included in the model. Even strategies based on low volatility behave much like portfolios of profitable companies that avoid aggressive investment.

For investors the lesson is straightforward.

The factor investing world has become crowded with complicated strategies and overlapping signals. But many of these approaches ultimately point back to the same underlying characteristic. Businesses that generate strong profits relative to their capital tend to perform better over time.

Instead of chasing dozens of specialized factor products, investors may be better served by focusing on a small set of core drivers of returns. Valuation matters. Momentum matters. And profitability appears to matter a great deal.

What Novy-Marx and Medhat show is that profitability is not just another factor in the expanding zoo of anomalies. It may be one of the central forces underlying many of them.

Quality investing, defensive equities, and several other fashionable strategies often succeed simply because they are quietly buying profitable companies.

Once you recognize that fact, the investment landscape becomes much easier to understand. The marketing labels fade away and the economics of businesses move back to the center of the discussion.

In the end the message is almost old-fashioned.

Profitable companies tend to be better investments than unprofitable ones.

And sometimes the most powerful insights in finance are the ones that sound the simplest.

The insight also suggests something practical for investors. If profitability sits underneath many of the most popular factors in the market, then one productive exercise is simply to look for businesses that generate strong profits but receive little attention from Wall Street or the financial media. Some of the most profitable companies in the market operate quietly in specialized niches, steadily generating cash while investors chase the next exciting theme. A handful of such companies illustrate the point rather well.

Fastenal $FAST ( ▼ 0.57% ) is one of those quietly dominant industrial businesses that rarely gets the kind of attention given to technology or consumer brands, yet it produces remarkable profitability year after year. The company distributes industrial and construction supplies through thousands of branches and on site customer locations. Its vending machines and inventory management systems allow manufacturers and construction companies to keep essential parts stocked while reducing procurement costs. This operational model produces steady revenue and high operating margins because customers become deeply integrated with Fastenal’s distribution system. The business generates strong free cash flow and has a long history of dividend growth. Despite those strengths the company operates in the unglamorous world of nuts, bolts, safety equipment and industrial consumables, which keeps it largely outside the spotlight of the financial media.

Hemnet Group HMNTY operates one of the most profitable digital platforms in the European real estate market. The company runs Sweden’s dominant online housing marketplace, where the vast majority of residential properties in the country are listed and marketed. Because nearly every home buyer in Sweden begins their search on Hemnet, real estate agents and sellers view the platform as an essential marketing tool. This powerful network effect allows the company to charge premium listing fees while maintaining a very asset light business model. The platform requires relatively little capital to operate, allowing a large portion of revenue to flow directly into profits and free cash flow. Despite its dominant market position and impressive profitability, Hemnet remains largely ignored by U.S. investors simply because it operates in a Scandinavian niche that rarely attracts global attention.

Mettler Toledo $MTD ( ▲ 0.34% ) is another example of a business that generates extraordinary profitability while remaining largely invisible outside specialized industrial circles. The company manufactures precision instruments used in laboratories, pharmaceutical manufacturing, food production and industrial quality control. These products measure weight, chemical composition and other variables with extreme accuracy. Because scientific and industrial processes require reliable measurement standards, laboratories tend to remain loyal to their chosen equipment suppliers for many years. This creates significant switching costs and allows Mettler Toledo to maintain strong pricing power and exceptional operating margins. The company’s instruments and services are essential tools for scientists and manufacturers, yet the business rarely receives the kind of media attention given to more consumer oriented technology companies. Quietly, however, it has produced some of the highest returns on invested capital in the industrial sector.

Lundin Gold $LUGDF ( ▼ 4.85% ) demonstrates that even in a volatile industry like mining it is possible to build a highly profitable operation. The company operates the Fruta del Norte mine in Ecuador, one of the highest grade gold deposits discovered in recent decades. High ore grades mean that the company can produce gold at relatively low cost compared with many competitors. Lower production costs translate directly into stronger operating margins and substantial free cash flow when gold prices are favorable. Management has taken a disciplined approach to capital allocation, focusing on efficient operations and returning cash to shareholders rather than pursuing aggressive expansion projects. Despite its strong profitability and cash generation, Lundin Gold receives little attention from the broader investment community because it is a mid-sized mining company operating outside the traditional North American mining centers.

Perdoceo Education $PRDO ( ▲ 0.08% ) represents another profitable business that sits well outside the spotlight of most investors. The company provides career-focused higher education programs through institutions such as Colorado Technical University and American InterContinental University. These schools emphasize flexible online learning programs aimed at working adults seeking professional advancement. Over the past decade Perdoceo has streamlined its operations, strengthened regulatory compliance and focused on programs with strong student demand. The result has been a highly profitable education company with solid operating margins, significant free cash flow and a strong balance sheet. The education sector has fallen out of favor with investors following years of regulatory scrutiny, which has allowed profitable operators like Perdoceo to remain largely overlooked despite generating steady earnings.

Each of these companies operates in a different industry and faces its own set of business risks. What they share is a simple characteristic that has proven extremely important in the academic research: they are consistently profitable businesses with strong operating economics. They generate substantial cash relative to the capital required to run the business, and they tend to maintain competitive positions that support those profits over time.

Sometimes the market overlooks exactly the kind of companies that academic research tells us we should be paying attention to. When profitability is one of the most powerful drivers of long term returns, businesses that quietly generate strong profits while receiving little attention can become especially interesting hunting grounds for investors willing to look beyond the headlines.