1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #86!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio In today’s episode, we discuss diversification, the value premium and the importance of the profitability factor
Enjoy!
2) DIVERSIFICATION, THE VALUE PREMIUN AND THE IMPORTANT OF THE PROFITABILITY FACTOR:
François Doyon La Rochelle:
James, I will start this off for our Listeners. Our recent Podcasts have addressed fundamental concepts for Investors. In our Podcast #84, we tackled Risk Profiling, covering the two components of Risk Tolerance and Risk Capacity. And in our most recent Podcast #85, we did an update on the Active vs. Passive debate.
Our Listeners know that the markets are now struggling with how to figure out the short- and long-term impacts of the War in Iran. No one has a crystal ball and can predict how it will turn out. At the end of the day, what is critical for Investors is how they will manage their emotions in this sea of negative headlines. We have been consistent in telling our listeners that it is imperative they tune out the noise in the financial media. But easier said than done.
This leads us to today’s topics, which will start with a discussion about diversification. We are also going to go beyond broad market stock exposures by doing an update on two other dimensions of diversification, which are the Value premium and the Profitability factor. So, James, where would you like to start?
James Parkyn:
Ok, François, let’s start with diversification. Last year in Podcast #75, we addressed this topic on diversification. We had just come off another year (2024) where US Stocks had massively outperformed Canadian and International stocks. In fact, they have outperformed for about 15 years since the end of the Global Financial Crisis in 2009. And as we reported in our year-end 2025 Capital Markets review Podcast, Canadian and International stocks finally outperformed US Stocks. Investors finally got the benefit of Global Diversification.
As most of our listeners know, the fundamental reason for Diversification is that it reduces risk. It allows investors either to earn the same expected return, with lower risk, or a higher expected return for the same level of risk. It is often described as a “free lunch” – or even the only free lunch in finance. For most Investors over the last 50 years, investing globally rather than just domestically has generated higher returns with the same level of risk. The exception has been US based investors because their domestic stock market outperformed.
François Doyon La Rochelle:
James, as always, our advice to our Listeners is that they should continue to invest globally. This is likely (but not guaranteed) to increase returns while reducing risk.
James Parkyn:
Absolutely Francois. Diversification should be one of the core principles of the structure of your portfolio. I have often heard that so-called financial experts state that only 10 to 20 stocks are needed for a diversified portfolio. This is nonsense. With broad market funds widely available at low cost, effective diversification is easy to implement, especially for a globally diversified portfolio. Being broadly diversified really matters partly because overall stock market returns are driven by very large returns for relatively few stocks.
François Doyon La Rochelle:
We have covered this in Podcast # 67 when we reviewed Professor Bessembinder’s research. Let me quote Bessembinder again: "Slightly more than 4% of the stocks that have been publicly listed in the U.S. since 1926 are responsible for all of the net wealth enhancement to shareholders. That is, long-run wealth enhancement in the public stock market is concentrated in relatively few stocks." This is where broad diversification will allow you to own these few stocks that actually generate long-term performance.
Now, James lets address how bonds provide diversification benefits.
James Parkyn:
Francois, Diversification across asset classes, as we know, is a powerful way of reducing portfolio risk. For Public markets, this means diversification between the two most important asset classes: stocks and bonds. As we reported in our Podcast #52 in 2023, the negative correlations between stocks and bonds over the last 20 years, prior to 2022, were not the norm. The long-term norm is that Stocks and Bonds have a historically positive correlation, and the stock-bond correlation tends to be negative during crises. This makes government bonds valuable diversifiers that can enhance the power of portfolio diversification when it is needed most. Over the very long run, the stock-bond correlation has averaged 0.33 across countries internationally and 0.19 in the US. This has provided a good scope for risk reduction.
François Doyon La Rochelle:
Yes, James, that is the flight to safety when markets are extremely volatile. From the late 1990s until 2021, stock-bond correlations were predominantly negative. What this means is that when stocks go down, bonds go up. Stocks and bonds were thus a hedge for each other, which was of great value to investors. These negative correlations were associated with a period of falling real interest rates, mostly accommodative monetary policy, generally low inflation, and low expected returns. The era of negative correlations ended abruptly in 2022 when stocks and bonds fell sharply together.
James Parkyn:
Francois, we have also seen that correlations within and between equity markets tend to increase in bear markets in times of crisis. An often-expressed worry is that diversification lets you down when you need it most. We feel that for long-term investors, these short-term uplifts to correlations should not be a major concern.
François Doyon La Rochelle:
James, now let’s discuss the issue of stock market concentration around the world, and on performance concentration in the US over recent years.
James Parkyn:
Francois, concentration is the opposite of diversification. Many markets around the world, especially the US, have become increasingly concentrated with the US now at its most concentrated in a century. It will come as a big surprise to many listeners, but in the 2026 UBS Yearbook Professors Dimson, March, and Staunton show that the US remains one of the world’s least concentrated markets, with 32 of the DMS 35 markets in their database being more concentrated. They have shown that the bigger challenge to investors has come from the performance concentration of the past few years, where the very largest US stocks have punched well above their (already large) weight in terms of their impact on overall market performance.
François Doyon La Rochelle:
Therein lies the compelling case for global equity diversification. We have seen this often when markets are volatile, globalization increases the extent to which markets move together, and over the longer term, the potential risk reduction benefits from international diversification remain large. Professors Dimson, March, and Staunton make the point that Global diversification can be oversold if it is presented as a surefire route to a superior return-risk tradeoff. It should certainly lead to higher expected levels of return for risk, but as they state, this is not assured.
James Parkyn:
Francois, I have a great quote on diversification from the great investment thinker, Peter Bernstein. “Somebody once said that if you’re comfortable with everything you own, you’re not diversified.” Bernstein, who died in 2009, added an observation: “I view diversification not only as a survival strategy but as an aggressive strategy, because the next windfall might come from a surprising place. I want to make sure I’m exposed to it.”
François Doyon La Rochelle:
James lets discuss the latest research about value stocks. Value stocks are another form of diversification. We know that the latest academic research highlights the importance of combining value stocks with a filter of the Profitability factor. So, James, where would you like to start?
James Parkyn:
Well, Francois, as you know, the value premium is one of the most widely studied premiums in equity investing. But now, the latest research highlights that Profitability has become a much bigger factor in the Value Premium debate.
François Doyon La Rochelle:
For our Listeners James, I think it would be useful to clarify what we mean by Value Stocks. Value Stocks are shares trading at low multiples of their book value. Growth stocks trade at high multiples of their book value. Value stocks also sell for relatively low multiples of earnings or dividends. They may be mature businesses with an unexciting future, or they may have a depressed share price.
James Parkyn:
Francois, recently, an article in the WSJ caught my attention. The WSJ Article entitled: “One of the Stock Market’s Last Havens Is Now at Risk. The Article goes on to state: “Value stocks have outperformed growth stocks by the biggest margin in years”. They go on to state: “The Russell 1000 Value Index is up 2.4% so far this year, beating the Russell 1000 Growth Index, which is down 9.1%, by the largest margin since 2022. Meanwhile, the S&P 500 index is down 3.8% and recently notched its worst quarter in nearly four years.” This recent rally in Value Stocks marks a shift from the dominating trend since the 2008-2009 Global financial crisis. The run-up in big US Tech stocks think the MAG 7 have powered US Stocks to outperform other global stock markets.
François Doyon La Rochelle:
U.S growth stocks have been struggling for a while, but they may reassert their dominance again before long, and the resurgence of value and international companies may fade. No one can ever say for certain when a market trend has shifted.
James Parkyn:
But Francois, that was precisely Bernstein’s point: “You don’t want all your eggs in one basket, because you never know when other baskets will do better.”
François Doyon La Rochelle:
This being said, despite the recent rally, Value Stocks remain cheaper than growth. An exchange-traded fund tracking the Russell 1000 Value Index recently traded at 16 times projected earnings over the next 12 months. Companies in the Russell 1000 Growth Index ETF traded at 24 times.
James Parkyn:
But Francois, what matters is the long-term data. Academic science supports the thesis that Valuations today and Expected future profitability will ultimately be the driver of returns. Our regular Listeners know we rely on financial and economic research evidence. Using data spanning nearly 100 years and from many markets around the world, academics and practitioners have found strong empirical evidence. Over the period from July 1926 to December 2014, the average Value premium over growth stocks in the US large-cap universe was 2.16% per year.
François Doyon La Rochelle:
But over the decade from January 2015 to December 2024, the realized premium was −11.6% per year. When something happens that does not match expectations, it’s natural to want to understand why. Value investing was a profitable strategy in the period covered by the key research studies. But the Jan 2015 - Dec 2024 period demonstrates the premium is not guaranteed . I would add James, the 1990s were mostly the era of growth stocks, and in comparison, value strategies fared poorly. After March 2000, value stocks performed well after the Tech bubble burst. However, growth stocks again did better than value stocks from 2007 onward.
James Parkyn:
So, Francois, what this demonstrates is that the Value premium does not show up. A recent Research brief that Dimensional published addresses the Growth outperformance and concludes that the unexpected higher Profitability of growth stocks is the explanation for this outperformance. In 2013, Professor Robert Novy-Marx published a highly regarded academic paper in which he highlighted the Profitability factor. Novy-Marx documented that profitability, broadly measured, has as much power as relative price (Value Vs. Growth), predicting differences in expected returns. Profitability has quickly become a prominent theme in asset pricing research, perhaps best illustrated by Fama and French’s (2015) inclusion of a profitability factor in their five-factor extension of the Fama and French three-factor model, which they published in 1993. It is also now a standard of many investment strategies, often promoted as quality investing.
François Doyon La Rochelle:
We have been working with Dimensional since 2003, and they have excelled at identifying academic findings that can be implemented in the products that we use in our clients’ portfolios. Dimensional discipline about managing portfolios based on academic science has led them to integrate expected profitability. This is on top of controlling for other dimensions of expected returns, such as relative price (Value Vs. Growth) and market capitalization (large cap vs. small cap). The evidence is that more profitable firms should have higher expected returns than less profitable firms.
So, what does the latest Research brief that Dimensional published tell us about Value and Profitability?
James Parkyn:
Well, Francois, Dimensional reports three major findings:
From 2015 to 2024, growth firms reported higher operating profits than their historical average, while value firms maintained their historical level.
While the spread in profitability between value and growth stocks has widened over time, so has the spread in valuations.
An effective way to capture premiums reliably is to take both current valuations and expected future profitability into consideration.
François Doyon La Rochelle:
James, this evidence suggests that a large part of the recent outperformance of growth stocks stemmed from unexpected earnings strength.
James Parkyn:
Yes, Francois, this is a key point that Dimensional makes. Many of the Mag7 stocks have generated large profitability levels that we have never seen in the capital markets. This has sparked the debate over whether the value premium is “dead.” There is an interesting paper recently published that adds to what Dimensional is saying. Professor Robert Novy-Marx and Mamdouh Medhat of Dimensional co-authored a paper in October 2025 titled “Profitability retrospective: What have we learned?” In this paper, they look into various “alternative” value strategies, all promoted with claims that they perform “better” than traditional value. Significantly, they show that accounting for profitability largely resolves recent debates around value, consistent with profitability’s characterization by Novy-Marx in his original 2013 paper as the “other side of value.” Profitability tilts drive “alternative” value strategies’ abnormal performance relative to traditional value.
This paper, Francois also goes on to state, and I quote: “for practitioners – that is, portfolio managers like us, the fact that seemingly distinct investment styles overlap more than commonly recognized suggests potential benefits from a simpler portfolio construction. Investment managers should carefully consider their portfolios’ exposure to profitability, as it is a key driver of returns across multiple investment classes.” They go on to state that: “Our results also suggest that explicitly targeting profitability, rather than relying on indirect proxies, is more efficient.”
François Doyon La Rochelle:
So, for our Listeners we can state that Dimensional is now making the Profitability a bigger factor in how they manage their Equity funds.
OK, so what can we conclude, James, about Diversification, the Value premium, and the importance of the Profitability factor?
James Parkyn:
Francois, the message is clear. Diversification is the only prescription. Going forward, if you want exposure to value stocks as part of your diversification strategy, combining Value Stocks based on Profitability factors will generate the best long-term results.
François Doyon La Rochelle:
James, I will end todays Podcast by reminding our Listeners that our discipline is to invest with “an Investor Mindset, focused on the long term”. We don’t want to be led astray by short-term noise in the financial media and by recent financial market volatility. This challenge is daunting and applies to all Investors including us Professionals. We have said it often on our Podcast: “It is simple to say but not easy to do: We must always be cognizant that we can fall into a trap of trying to 'Forecast the Future”
3) CONCLUSION
François Doyon La Rochelle:
Thank you, James Parkyn for sharing your thoughts and expertise again today.
James Parkyn:
You are welcome, François.
François Doyon La Rochelle:
So, that’s it for episode #86 of Capital Topics!
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