A Different Way to Find Value

by: John P. Reese

The stock investing world is filled with well-known valuation metrics -- the price/earnings ratio, price/book ratio, free cash flow yield, price/sales ratio, and numerous other variables have been used by successful investors to find winning stocks.

A new study shows, however, that a much less popular valuation metric -- the gross profits-to-assets ratio -- may be one of the better predictors of future stock performance.

The study, entitled “The Other Side of Value: Good Growth and the Gross Profitability Premium”, was performed by Robert Novy-Marx of the University of Chicago and National Bureau of Economic Research. (A tip of the cap to The Stingy Investor and CXO Advisory Group for highlighting the research.) In it, Novy-Marx finds that the gross profits/assets ratio is actually a better predictor of future returns than more widely used earnings- and cash flow-based valuation metrics.

"In a horse race between these three measures of productivity, gross profits-to-assets is the clear winner," Novy-Marx writes. "Gross profits-to-assets has roughly the same power predicting the cross-section of expected returns as book-to-market. It completely subsumes the earnings based measure, and has significantly more power than the measure based on free cash flows." In addition, he says the gross profits/assets measure is a predictor of long-term earnings and free cash flow growth.

Novy-Marx's research, which covers the period from July 1963 to December 2009 and excludes financial firms, finds that companies in the top fifth of the market based on gross profits/assets returned 0.33% per month more than those in the bottom fifth. "Profitable firms generate significantly higher average returns than unprofitable firms, despite having, on average, lower book-to-markets and higher market capitalizations," Novy-Marx writes.

He also finds that a portfolio that is half made up of high gross profit/assets stocks and half made up of high book/market stocks would have generated average monthly excess returns of 0.75%. And he adds, "Controlling for gross profitability explains most earnings related anomalies, as well as a wide range of seemingly unrelated profitable trading strategies."

Novy-Marx's research got me thinking about which high gross profit/assets firms also get high marks from my Guru Strategies, each of which is based on the approach of a different investing great. Here are some of the best of the bunch, along with their gross profit/assets ratio and the Guru Strategies that are keen on the stocks.

Disclosure: I'm long TJX, LLY, GILD, PM, JNJ, BMY, KO, PEP, INTC, CVS, EBAY, UPS, ABT, and PG.