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Quality Effect

ONE OF THE MORE recent contributions to factor investing comes 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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Bob Wilmes
Bob Wilmes
2 months ago

I used to go to my local university library and look at the consolidated Standard & Poor’s weekly paper listings for companies looking for outsized gross profit margins. I found many were in industries with high intellectual property content such as pharmaceuticals or entertainment. Oftentimes the companies made fantastic returns, but they were inefficient in reinvesting their own profits. Case in point was the old Kodak company – great profits, eventually undone by digital cameras, even though Kodak owned most of the early patents on digital cameras. Another was Xerox and the Palo Alto Research Center – they were unable to capitalize on their own inventions which their executives ignored and eventually became a call center outsourcing company.

My thinking changed over the years to look for companies with strong founders who demonstrated the ability to change. Steve Jobs was one but An Wang, who founded Wang Laboratories was not. I am sure at some point today’s stock market wunderkind like Apple, Google, Netflix, facebook will be extremely challenged when their patents expire (here’s looking at you Larry Page and Sergey Brin) or a newer more fundamental technology disrupts the technology ecosystem.

Part of Warren Buffett’s genuine genius is he has long recognized companies like See’s candy, which continue to create strong profits without the need for continual reinvestment in technology. Or they are in regulated industries like power generation, which are guaranteed a continual return on invested equity.

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