Quality Effect

WHILE MANY OF THE relatively recent contributions to factor investing haven’t withstood close scrutiny, one has caught on—that from Robert Novy-Marx, a finance professor at the University of Rochester (“The Other Side of Value: The Gross Profitability Premium,” Journal of Financial Economics, 2013, Vol. 108, No. 1). He examined the stock market performance of companies based on their profitability, as measured by the ratio of gross profits to assets. Gross profits are a company’s revenues minus what it cost the company to make the goods that were sold.

Don’t confuse gross profits with net income, which is the earnings number that investors typically look at. Novy-Marx notes that net income isn’t necessarily a good indicator of profitability because it can be depressed by, say, spending on research and development or an aggressive advertising campaign. That spending can mean greater profits down the road, yet it takes a short-term toll on reported earnings and thus can make companies look less profitable than they really are.

Novy-Marx found that buying companies with high gross profits, which is a form of growth investing, generates higher stock market returns. He also found that the strategy is especially effective if you buy more profitable companies, but focus on those with lower share prices relative to book value. In other words, by combining Novy-Marx’s quality criteria with French and Fama’s value criteria, you should be able to identify stocks that are profitable but undervalued.

It would be hard to argue that buying more profitable companies is a riskier strategy, so there’s a greater danger that the premium offered by the quality (or “profitability”) effect will disappear relatively quickly. Among the funds focused on this area are iShares MSCI USA Quality Factor ETFiShares MSCI International Quality Factor ETF and Vanguard U.S. Quality Factor ETF. As these funds and others seek to exploit Novy-Marx’s insight, the stocks involved could see their prices bid up—and future returns will be lower.

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