The Other Side Of Value by SG Value Investor, The Value Edge
Recently, I was reading an equity research write-up that prompted me to research further into a financial measure called ‘Gross Profitability’, measured by Gross Profits divided by Total Assets (GP/TA). In the research paper written by Noxy-Marx in 2010, he discusses that GP/TA ratio is actually a better predictor of future returns than more widely used earnings- and cashflow- based valuation metrics.
In a horse race between these three measures of productivity, gross profits to assets is the clear winner – Novy-Marx
His argument is compelling for the following reasons.
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Firstly, using Gross Profits instead of Earnings. Gross Profits is the cleanest accounting measure. If we think about it, as we go further down the income statement, the more ‘polluted’ profitability measures become. Say if a firm generates higher revenue and has a lower cost of production compared to their competitors, they are unambiguously more profitable. Despite that, the firm can still have lower earnings. Reason being, the firm could be increasing their revenues through aggressive advertising, or commissions to their sales force. Such actions would ultimately reduce their bottom line income compared to their less profitable competitors. Additionally, the firm could be improving their production chain through research and development, investing in capital structures to maintain their competitive advantage, resulting in lower earnings again. Furthermore, such capital expenditures would too lower the firm’s free cash flows. Hence, the rationale behind Gross Profit instead Earning is very convincing.
Secondly, by using Total Assets, instead of say Market Value avoids merging the productivity proxy with book-to-market. By scaling Gross Profits by Book Assets, not Book Equity, Gross Profits would not be reduced by interest payments and are thus independent of leverage.
Lastly, to put it simply the results have proven that GP/TA has outperformed the other metrics. For a more detailed read on the results, one would be able to read the research paper found here. While, a summarized version to the best of my understanding is as follows. For each month, he sorted all firms into 5 quintiles based on the level of GP/TA. On a raw non-risk-adjusted basis, the stocks in the highest profitability quintile earned a monthly return 0.33% higher than the stocks of the lowest profitability quintile. This would result to approximately 4.03% a year. While on a risk-adjusted basis, the L/S strategy brings about 0.55% returns a month. The monthly return of high book-to-market companies is 0.42% higher than the returns of low book-to-market companies. One point to note would be that profitable firms tend to be growth firms, while unprofitable firms tend to be value firms. For an investor running the two strategies together, they would capture both strategies’ returns, 0.75% per month and face no additional risk.
In the nutshell, I feel that the main takeaway from this article should be the understanding of this new metric and how to go about using it. I have compiled a list of the highest profitability quintile companies found here. Knowing the range of the top 20% of companies, it allows us as investors to know where a certain company may stand in the entire market. The biggest concern I have would be that should I have split the market into the different industries, followed by identifying the highest profitability quintile companies within each industry. Essentially, this method of using gross profitability is used to determine the ‘quality’ of companies.