While many academic studies highlight value measures that investors can use to construct market-beating portfolios, researchers have not been able identify quantitative growth factors that help investors build portfolios that outperform the market on a risk-adjusted basis. New research by Robert Novy-Marx, an assistant professor of finance at the Simon Graduate School of Business at the University of Rochester, looks to change that.
Novy-Marx reminds us that Benjamin Graham did not just focus on buying cheap stocks. Rather, Graham looked for undervalued companies—high-quality firms selling at attractive prices. Graham argued that it is best to build a portfolio of undervalued stocks that are being ignored or discriminated against by the market. Graham’s approach focused on the concept of an intrinsic value that is justified by a firm’s assets, earnings, dividends and financial strength.
Unfortunately, tests of many of the most popular measures of company growth and financial strength, such as past or expected earnings growth or return on equity, do not reveal strategies that could be used to select stocks poised to outperform the market as well as value measures such as low price-to-book-value ratios or low price-earnings ratios.
Most investors focus on the bottom line of the financial statement to measure company success and growth. Novy-Marx discovered that the firm’s gross profit is a much better predictor of future success and stock market performance than bottom-line earnings or even cash flow. Furthermore, since this test for quality growth is not highly correlated with value measures, investors can combine growth and value tests to build more diverse portfolios.
Novy-Marx’s test for quality growth revolves around gross income (gross profit). Gross income, which is calculated by taking revenueand subtracting the cost of goods sold, represents the amount of profit a company earns by selling its products or services. Cost of goods sold is the cost a firm incurs by manufacturing or producing an item, such as material and direct labor costs. Gross profit reflects a firm’s basic pricing decisions and its material costs. The greater the gross profit and the more stable it is over time, the greater the company’s expected profitability. Trends are closely followed because they generally signal changes in market competition. If product costs are increasing, they will have to be either absorbed by the company, hurting profits, or passed on to the consumer, potentially hurting revenue.
Investors normally scale or compute a ratio from gross income so that it can be tracked over time and compared against other firms that are different in size. Typically, a gross margin figure is computed by dividing gross income by total revenue. The percentage reflects the proportion of gross profits earned from each dollar of revenue.
Novy-Marx scaled gross income to total assets rather than total revenue. Gross profit to assets is revenue minus cost of goods sold divided by total assets. By comparing gross profit to assets, investors are getting a snapshot as to whether or not the firm’s assets are profitable. Since the profitability test is measured so near the top line, it is considered a very clean measure of economic profitability. Novy-Marx feels that profitability measures get more “polluted” as one goes further down the income statement. He argues that a firm that has lower production costs (higher gross margins) and higher sales than its competitors is more profitable. However, it can have lower earnings than its competitors if it is expanding sales with an advertising campaign and establishing a larger sales force. These types of expenditures will not impact gross profits but may hurt operating profits as well as net income in the short term. Research and development outlays will also hurt bottom-line profitability until the research benefits result in higher sales or margins. Simple screens for earnings growth or earnings profitability have a difficult time distinguishing firms that have reduced earnings because they are investing for future growth from firms with lower overall product sales and profitability.
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