How to Take Advantage of the Gross Profitability Premium

A newer valuation measure continuing to be supported by academics is the gross profitability premium. First identified by University of Rochester professor Robert Novy-Marx, this anomaly favors stocks with high levels of gross profits scaled by assets. An article in the July Journal of Banking and Finance by Arizona State professor David Kenchington and his two co-authors found that mutual funds holding stocks with high levels of gross profitability outperform by a sizeable margin.

There’s a bit to unpack here, so I’ll start by explaining what the gross profitability anomaly is. It is the ratio of gross profits (revenues less cost of goods sold) to total assets. Rather than relying solely on the income statement, Novy-Marx tied profitability to the balance sheet. Doing so helps to analyze how effectively a company is using its assets to realize gross profits. (A bloated balance sheet will reduce the ratio.) Novy-Marx himself views gross profits as a growth indicator since net earnings can be “punished” for growth-related activities such as advertising and research & development.

Calculating the gross-profit-to-assets ratio is easy for a single stock. You simply need sales and cost of goods sold for the past 12 months (found at the top of the income statement) and total assets for the most recently reported quarter (found on balance sheet). Determining how one company’s gross profitability compares to others is trickier because the measure is not widely available. You would need to use a screener to gather the data on a large number of companies to determine the ranks. Using the same formula that my colleague Wayne Thorp previously used of (Gross income 12M/Total assets Q1)*100 on nonfinancial exchange-traded stocks with reported earnings for this current year, the top quintile of companies had gross profitability ratios of approximately 45 or higher. The table at the bottom of today’s commentary shows the stocks with the 10 highest gross profitability premium ratios.

The ratio is considered to be an anomaly because it contradicts the efficient market hypothesis (EMH). The pure form of EMH holds that stock prices reflect all known public information. If the market was completely efficient, then there shouldn’t be any performance advantage to buying stocks based on their gross-profit-to-assets ratio (or their valuation, size, price momentum, etc.). Yet, there is an advantage to doing so.

There is also an advantage to buying mutual funds focusing on the gross profitability premium. Mutual funds holding stocks whose gross-profit-to-assets ratios ranked in the top quintile (top 20%) realized a 1.96-percentage-point advantage in net annual returns over funds holding stocks whose gross-profit-to-assets ratios ranked in the bottom quintile. On a top-to-middle basis, funds targeting top quintile stocks outperformed funds holding middle quintile stocks (20% to 80% range of gros- profit-to-assets ratios) by 1.21 percentage points per year.

Unfortunately for those of you who want to know which funds these were, the study’s authors did not name them. They did give some clues as to where to look. Funds using this ratio tend to be younger, smaller, charge higher expense ratios, have higher levels of portfolio turnover and are more actively managed (as indicated by their comparatively lower R-squared values). Dimensional Fund Advisors (DFA) and AQR Capital Management were cited as having “incorporated measures similar to gross profitability in their trading strategies.” AQR Capital has some mutual funds and exchange-traded funds (ETFs) open to the general investing public, while DFA funds are only sold through select advisers. In all cases, you will have to look through the fund’s prospectus and materials to see whether the manager purposely incorporates the gross profitability premium.

As far as individual stocks are concerned, the list below is based on a screen of nonfinancial exchange-listed stocks with market capitalizations of at least $30 million. Novy-Marx’s research suggested that the factor was stronger among larger companies, while Kenchington et al. found it to work for both small-cap and large-cap funds. The list should be viewed as merely a starting point for further research.