Gross Profit, Great Gains

I have long held the opinion that for most investors the money is made on the edges. The two top performing strategies I have uncovered over the years are deep value and what I call real growth. Real growth companies are those that are growing revenues, earnings and the net value of the firm higher consistently over the years. It is basically an earnings momentum and growth strategy based on high profitability and management execution. As long time readers are aware I am a bit of a geek and spend a good amount of time reading academic research and I recently forum a paper that basically confirms my thoughts on this subject and brings some interesting new data and possibilities for individual investor.

Robert Novy-Marx is a professor at the University of Rochester and a fellow at the National Bureau of Economic Research. His research efforts are spent studying asset pricing, real estate and finance, He recently produced two studies that are of interest to me as a value investor. The first paper has the provocative name of The Other Side of Value: Good Growth and the Gross Profitability Premium that was originally published in Journal of Financial Economics. The other is a working paper titled the Quality  Dimension of Value Investing. The papers make two discoveries that are extremely useful to us as long term value investors.

The first is that companies with a high level of profitability are as useful as price to book value when it comes to predicting future performance of their shares. However he eschewed the usual standards of profitability such as earnings per share and return on equity. He remarked in one paper that “gross profitability performs better predicting future stock returns than ROE, the profitability variable most frequently employed in earlier academic studies, because it is a better proxy for true economic profitability. In particular, the study points to the fact that accountants treat many forms of economic investment (e.g., R&D, advertisement, sales commissions, and human capital development) as expenses, so these activities lower net income but increase future expected profitability. This makes earnings a poor proxy for true expected economic profitability.” He compares group profitability to total assets an finds that those stocks with high gross profits as a percentage of assets used to produce the profits as the best way to measure profitability.

His study cover a period from July 1963 to December 2012 and finds that stock with high profitability using his measures outperform the market at a rate comparable to those that fit in to the classic deep value approach. The conclusion supports my conclusion that investors would do better focusing on the what I call true growth firms and what he calls profitable firms and classically cheap stocks based on book value. While I prefer picking one for or the other there is a suggestion n the data that investors might be best served by focusing on both strategies.

While that seems like an interesting concept and would probably work very well over the long term the two studies give us another useful idea to apply it the investing process. What would happen if you combined the profitability factor with traditional value approaches? You end up outperforming the market, straight value approaches, and true growth strategies by a pretty significant margin with lower drawdowns and fewer years of underperformance according to the study. It works on both large and small cap stocks over a long period of time. He concludes the study by saying “The basic message is that investors, in general but especially traditional value investors, leave money on the table when they ignore the quality dimension of value.

I am a geek but I am also a cynical optimist. I had to go back and look at some results for myself and how it has worked recently. I looked back one year and selected stocks that had high profitability using Mr. Novy -Marx’s profitability calculation and also traded below tangible book value. The results are incredible. The list of stocks over $100 million in market cap returned on average 45% over the past year. 79% of the profitable value stocks are higher a year later. For the microcap stocks under $100 million the average return was 54.8% and 70% of the small profitable value stocks went higher.

Naturally I then sat down and ran the screen on the current universe of stocks. I found two things to be of great interest. The first is that there are a lot fewer cheap profitable companies right now than there were this time a year ago. The second is that there are some pretty interesting names of the list worthy of further exploration by long term value investors.

That is impressive performance to say the least so I quickly built a screen that looked for cheap stock that have very high gross profits when compared to their asset base.I found some surprises when I ran the screen. Some companies you might not think of as wildly profitable actually are when you measure it by gross profitability. Keep in mind that gross profitability is simply total sales minus cost of goods sold and leaves out all the overhead and other expenses. Mr. Novy- Marx found that this was the best measure of profitability and that it has strong predicative value so that is the one we will use.

Arcelor Mittal  (MT) is  a large integrated steel company and one would not necessarily think of it as wildly profitable as they have struggled in recent years. They took a bottom line loss in 2012 but had managed to paint the bottom line black in the preceding decade. The CEO of the company recently told investors he believed the company had turned the corner and should see conditions in the steel market in 2014. When we measure it in terms of gross profitability compared to assets we find that the company has assets of $112 billion and gross profits over the last four quarters have been a little over $74 billion. That is one of the cheapest ratios in the deep value high profits screen. The stock is certainly cheap trading at less than 60% of tangible book value.

I almost feel out of my chair I when saw Radio Shack (RSH) on the list of high profitability cheap stocks. This has been one of dogs the past few years as I was way to early buying the stock in anticipation of a turnaround or takeover. The company has its issues but it also has a very high level of gross profitability with $1.4 billion of gross profits in the past year on an asset base of $1.9 billion. The stock is still cheap at 78% of book value so if they can find a way to improve the items between gross profits and the bottom line my patience may yet be rewarded.

I was further happily surprised that although my credit and fundamental models use a lot more than 1 factor the gross profitability and book value combination picked  out a lot  of the companies I have mentioned here on Real Money and own for myself as well as family and friends. Stocks like Kimball International (KBALB), Xyratex (XRTX), Real Networks (RNWK) and Sky West (SKYW) have very high gross profits as a percentage of assets.  Transworld  Entertainment  (TWMC)is one of the stocks I hate to love as I think the brick and mortar music and video stores is an industry in the way out but those stock has high gross profits as a percentage of asset and trades at just 85% of book value.

 So do a couple of companies I have had my eye on but haven’t pulled the trigger and purchased yet. Tropicana Entertainment is Carl Icahn’s casino empire based purchased out of bankruptcy a few years back. They now own casinos in Nevada, Indiana, Louisiana, Mississippi, and New Jersey as well as one in Aruba. The stock may not do much until Carl decides to sell or otherwise transform the company but it trades at just 3 times gross profits and 80% of tangible book value.

I have also been negative on for profit education stocks for several years now and Apollo Group (APOL) is one of the best shorts I have ever put on in my life. However many of the stocks in the group such as Corinthian Colleges (COCO) and Career Education (CECO) are now trading below book value and have high gross profits when compared to assets. I haven’t bought in yet as I am still a fan of the business model but the valuation is getting quite compelling.

The idea of using gross profits as a measure of profitability when selecting stock is clearly effective and should be an arrow in every investors analytical quiver. When used with value stocks it appears to work extremely well at locating stocks that can survive to thrive.