Readers of the Seventies hippie bestseller, "Zen and the Art of Motorcycle Maintenance" may remember long, interminable digressions into the nature of "Quality". For those that haven't read it, the book describes the author's journey with his son by motorcycle from Minnesota to California. Along the way, the author (Robert Pirsig) recalls his past self as a young man, who he calls Phaedrus. Phaedrus is a gifted teacher of creative writing at a small college, who becomes obsessed with the question of what defines good, or "quality". These philosophical investigations eventually drive him insane, leading to him being subjected to a particularly nasty episode of electroshock therapy.
A cautionary tale perhaps for those that spend too much time meditating on quality - it can hurt your brain. But when it comes to investing, it sure feels like the concept needs a bit of intellectual elbow-grease.
What do we really mean by Good / Quality?
There have been reams upon reams written about value investing and about the pros and cons of different value measures. Entire forests have been sacrificed for the sake of dissecting metrics like the price/earnings ratio, the price/book ratio, free cash flow yield, or the price/sales ratio! So we know, pretty much inside out, what "cheap" means. But, in contrast, the concept of "good" is much more fuzzy!
Many have noted that Warren Buffett, the world's most famous investor, has evolved from just being a Graham-style bargain value investor to something else... but what is that exactly? Buffett still likes cheap but he also likes good, high quality businesses. As he wrote:
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price".
But what does he really mean by wonderful? What signals quality? As we've discussed, Buffett-esque Quality is tied up with ideas like a good management team, a differentiated product, a good "economic moat", or barriers to entry.
Well yes, but these all seem like rather vague and subjective notions, aren't they? They lie in the eye of the beholder. One man's first class CEO may be another man's joker. A seemingly unbreachable economic moat may look narrow to someone else. Is there a way of making quality a bit less... well, less qualitative? Is it possible to find quantitative signals that tell us that we're dealing with a quality business? Said another way, what objectively defines a company like Apple (NASDAQ:AAPL) as being "great"?
How Much Quality Matters
On this front, there's been some interesting - but rather troubling - recent work by Robert Novy-Marx of the University of Rochester. In a 2010 paper called "The other side of value: Good growth and the gross proﬁtability premium", Novy-Marx looked in depth at one measure of quality, namely "gross profitability" defined as Gross Profit divided by Assets. His work found that companies in the top fifth of the market based on this measure returned 0.33% per month more than those in the bottom fifth. His conclusion: High quality firms generated significantly higher average returns than low quality firms, despite having high valuations on average.
Interestingly, Novy-Marx found that the gross profits/assets ratio is actually more predictive than widely used earnings- and cash flow-based valuation metrics. He notes that:
"in a horse race between these three measures of productivity, gross profits-to-assets is the clear winner".
Gross Profits: Are You Fricking Serious?
This is puzzling stuff. From a common sense business perspective, gross profits feels to us like a fairly crappy measure of quality. What gross margin tells you is how profitable the business is before subtracting all expenses apart from the cost of sales. That's it. It just nets off the cost of the materials or labor used to make the products/services sold. So forget about SG&A, i.e expenses not directly related to sales such as rent, lease, utilities, salary, marketing, etc. And R&D investments that companies make in developing new and better products or services. And interest, taxes, and depreciation.
Instinctively, you would have thought a measure like ROCE to be a far better test of Quality. There's a great discussion on why sustainable ROCE make so much sense which I won't bother to replicate now but, as Warren Buffett notes in his 1992 letter:
"Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.
The one really good argument Novy points forward in favour of Gross Profits to Assets is that, unlike other metrics, quality focuses on the top line rather than the bottom line. As such, it is a relatively "clean" measure of economic proﬁtability. The farther down the income statement one goes, the more polluted proﬁtability measures become, and the less related they are to true economic proﬁtability.
That's a fair point but the idea that you can judge two companies before their SGA & other costs are taken into account still seems crazy. The kind of thing that would only have been conjured by someone with no experience of running a business. Some companies have an economic moat entirely based around their sales techniques - including their marketing and advertising techniques.
Furthermore, there are also huge differences across industries. In some industries, like clothing for example, gross profit margins are expected to be near the 40% mark, as the goods need to be bought from suppliers at a certain rate before they are resold. In other industries such as software product development, since the cost of duplication is negligible, the gross profit margin can be higher than 80-90% in some cases. Does that mean that technology investments are inevitably higher quality? Admittedly, we are going through a major transition to digital at the moment, but logically that idea makes no sense.
So maybe there's a bit of data mining oddness or misinterpretation going on here (we discuss the danger of data snooping here). Still, Novy's work does seem to picking up an important effect. It's hard to argue with this stunning chart from the Novy Marx paper:
None of our qualms seem to have stopped AQR Capital from jumping on this particular bandwagon. The Wall Street Journal reports that a Greenwich-based asset manager is set to launch a set of investment funds based specifically on Novy-Marx's research. So - never wanting to spoil a good party - we've now added Gross Profits to Assets by popular demand to our screening library so subscribers can have a play around with it.
The Truth is Out There...
In fairness to Mr Novy-Marx, he weighs up Gross Profitability against a range of other quality strategies, including our old friend the Piotroski F-Score, in another excellent 2012 paper called "The Quality Dimension of Value Investing". In a subsequent post, we'll be looking at how Novy's measure stacks up these other measures, and - in turn - the rationale for the mix of elements we've chosen in our own QualityRank. Assuming, that is, we aren't subjected to any electroshock therapy in the meantime!