Value investing traces its roots to Benjamin Graham who, in 1934, advocated buying stocks at a deep discount to their intrinsic value. It is important to realize that this does not mean buying cheap stocks. Instead, Graham sought to identify high-quality, long-term assets. However, researchers have been hard-pressed to come up with a measure of financial strength as successful in selecting stocks poised to outperform the market as value measures such as the low price-to-book-value ratio.
That may have changed, however, with new research from Robert Novy-Marx, an assistant professor at the Simon Graduate School of Business at the University of Rochester. He found that gross profitability does as good a job at predicting a company’s future returns as conventional value measures. Furthermore, since this test for “quality” is not highly correlated with value measures such as the price-to-book-value ratio or the price-earnings ratio, investors can combine growth and value tests to build more diversified portfolios. He presented his results in two related research papers: “The Quality Dimension of Value Investing” and “The Other Side of Value: The Gross Profitability Premium.”
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