The Other Side Of Value: Good Growth And The Gross Profitability Premium
Robert Novy-Marx
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
April 2010
Abstract
Profitability, as measured by gross profits-to-assets, has roughly the same power as book-to-market predicting the cross-section of average returns. Profitable firms generate significantly higher average returns than unprofitable firms, despite having, on average, lower book-to-markets and higher market capitalizations. Controlling for profitability also dramatically increases the performance of value strategies, especially among the largest, most liquid stocks. These results are difficult to reconcile with popular explanations of the value premium, as profitable firms are less prone to distress, have longer cash flow durations, and have lower levels of operating leverage, than unprofitable firms. Controlling for gross profitability explains most earnings related anomalies, as well as a wide range of seemingly unrelated profitable trading strategies.
The Other Side Of Value: Good Growth And The Gross Profitability Premium – Introduction
Profitability has roughly the same power as book-to-market predicting the cross-section of average returns. It is also complimentary to book-to-market, contributing economically significant information above that contained in valuations. These conclusions differ dramatically from those of other studies (Fama and French (1993, 2006)), which find that profitability adds little or nothing to the prediction of returns provided by size and book-to-market. The difference is that “profitability” here is measured using gross profits, not earnings. Gross profitability represents “the other side of value.” Strategies based on gross profitability generate value-like average excess returns, despite being growth strategies that provide an excellent hedge for value. Because the two effects are closely related, it is useful to analyze profitability in the context of value.
Value strategies hold firms with inexpensive assets and short firms with expensive assets. When a firm’s market value is low relative to its book value, then a stock purchaser acquires a relatively large quantity of book assets for each dollar spent on the firm. When a firm’s market price is high relative to its book value the opposite is true. Value strategies were first advocated by Graham and Dodd in 1934, and their profitability has been documented countless times since.
Berk (1995) argues that the profitability of value strategies is mechanical. Firms for which investors require high rates of return (i.e., risky firms) are priced lower, and consequently have higher book-to-markets, than firms for which investors require lower returns. Because valuation ratios help identify variation in expected returns, with higher book-to-markets indicating higher required rates, value firms generate higher average returns than growth firms.
A similar argument suggests that firms with productive assets should yield higher average returns than firms with unproductive assets. Productive firms for which investors demand high average returns to hold should be priced similarly to less productive firms for which investors demand lower returns. Variation in productivity therefore helps identify variation in investors’ required rates of return. Because productivity helps identify this variation, with higher profitability indicating higher required rates, profitable firms generate higher average returns than unprofitable firms. This fact motivates the return-on-asset factor employed in Chen, Novy-Marx and Zhang (2010).
Gross profits is the cleanest accounting measure of true 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. For example, a firm that has both lower production costs and higher sales than its competitors is unambiguously more profitable. Even so, it can easily have lower earnings than its competitors. If the firm is quickly increasing its sales though aggressive advertising, or commissions to its sales force, these actions can, even if optimal, reduce its bottom line income below that of its less profitable competitors. Similarly, if the firm spends on research and development to further increase its production advantage, or invests in organizational capital that will help it maintain its competitive advantage, these actions result in lower current earnings. Moreover, capital expenditures that directly increase the scale of the firm’s operations further reduce its free cash flows relative to its competitors. These facts suggest constructing the empirical proxy for productivity using gross profits.1 Scaling by a book based measure, instead of a market based measure, avoids hopelessly conflating the productivity proxy with book-to-market. I scale gross profits by book assets, not book equity, because gross profits are not reduced by interest payments and are thus independent of leverage.
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