The Quality Dimension of Value Investing by Robert Novy-Marx
Robert Novy-Marx is assistant professor of finance at the Simon Graduate School of Business at the University of Rochester, New York, and a faculty research fellow of the National Bureau of Economic Research.
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Buying high quality assets without paying premium prices is just as much value investing as buying average quality assets at discount prices. Strategies that exploit the quality dimension of value are profitable on their own, and accounting for both dimensions of value by trading on combined quality and price signals yields dramatic performance improvements over traditional value strategies. Accounting for quality also yields significant performance improvements for investors trading momentum as well as value.
Benjamin Graham will always be remembered as the father of value investing. Today he is primarily associated with selecting stocks on the basis of valuation metrics like price-to-earnings or market-to-book ratios. But Graham never advocated just buying cheap stocks. He believed in buying undervalued firms, which means buying high quality firms cheaply.
Graham was just as concerned with the quality of a firm’s assets as he was with the price that one had to pay to purchase them. According to Graham, an equity investor should “…apply a set of standards to each [stock] purchase, to make sure that he obtains (1) a minimum of quality in the past performance and current financial position of the company, and also (2) a minimum of quantity in terms of earnings and assets per dollar of price”
(Graham 1973, pp. 183). Of the seven “quality and quantity criteria” that Graham suggested a firm should meet for inclusion in an investor’s portfolio, five were directly concerned with firm quality, while only two were related to valuation.
While Graham devoted as much attention to the quality dimension of value as its price dimension, he is nevertheless primarily associated with buying firms cheaply because it is his valuation metrics that have delivered
exceptional returns. Value investing is on average quite profitable, but the quality metrics Graham employed have not reliably forecast relative stock performance.
The last decade has seen resurgent interest, however, in quality investing. Quality is often viewed as an attractive alternative to traditional growth, which performed terribly during and after the dot-com bust. Its leading industry proponents include GMO’s Jeremy Grantham, whose high quality indicators of “high return, stable return, and low debt” have shaped the design of MSCI’s Quality Indices, and Joel Greenblatt, whose “Little Book that Beats the Market” has encouraged a generation of value investors to pay attention to capital productivity, measured by return on invested capital, in addition to valuations.
There has also been increased interest in incorporating academic measures of quality into value strategies. BlackRock, the earliest adopter (when still BGI) of Sloan’s (1996) accruals-based measure of earnings quality, is currently promoting the benefits of integrating earnings quality into global equities strategies (Kozlov and Petajisto, 2013). Piotroski and So (2012) argue that strategies formed jointly on valuations and another accounting based measure of financial strength, the Piotroski’s (2000) F-score (which uses both
Sloan’s accruals and aspects of Grantham’s quality among its nine components), have dramatically outperformed traditional value strategies.
Societe General has appropriated Piotroski’s F-score (without attribution) as the primary screen it employs when constructing its Global Quality Income Index, launched in 2012 (Lapthorne et. al., 2012).
Novy-Marx (2013) finds that a simpler quality measure, gross profitability (revenues minus cost of goods sold, scaled by assets), has as much power predicting stock returns as traditional value metrics. Strategies based on gross profitability are highly negatively correlated with strategies based on price signals, making them particularly attractive to traditional value investors. Novy-Marx’s results have influenced the design of both DFA’s growth funds and
AQR Capital Management’s core equity funds. DFA believes that “…the research breakthrough in this case is not the discovery of expected profitability as a dimension of expected returns per se… [but] the discovery of reasonable proxies for expected profitability, which allow us to use profitability as another dimension of expected returns in the creation of investment solutions” (Chi and Fogdall, 2012). Cliff Asness of AQR, which is using profitability in conjunction with value and momentum signals, says that:
Profitability is sometimes, not inaccurately but confusingly, referred to as a ‘growth’ strategy. This is confusing as for a long time ‘growth’ has come to mean simply the opposite of value, and obviously that is a bad idea! Rather, a simple value strategy does not distinguish between an expensive stock that is high quality (profitable), and one that is low quality (unprofitable). Nothing in theory, Graham and
Dodd, or the basic discounting equation says this is a good idea. It turns out to work because the value effect is so strong that it can afford to ignore quality, but that doesn’t mean that ignoring quality is optimal. Including measures of profitability along with measures of value in the same portfolio effectively makes ‘value’ into a better value strategy, as it’s one that distinguishes between stocks at low or high multiples for a reason (profitability) from those at similar multiples without such a reason. Whether one thinks of the two together as simply a better value strategy, or as two separate effective strategies, the end result is the same. A portfolio of value stocks constructed with some additional consideration of profitability is a better portfolio. (Private correspondence, 2013)