The Profitability Factor

In 2012 Robert Novy-Marx wrote the paper The Other Side of Value:The Gross Profitability Premium. You could say that it is an attempt to test the hypothesis of Charles Munger and Warren Buffett that it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

The Gross Profitability Premium

Novy-Marx measures profitability by using a ratio of gross profit to assets. Efficiency ratios such as the Du Pont analysis (asset turnover x profit) have been used for a long time in finance and accounting, but the unconventionality of his approach is by only using the cost of goods sold and disregarding other costs.

Novy-Marx’s Conclusion

Looking at NYSE firms between 1963 and 2010 and international firms between 1990 and 2009 (ex-financials), Novy-Marx discovered that a company’s gross profitability did as good a job at predicting its future returns as conventional value metrics like book-to-market. More profitable companies today tend to be more profitable companies tomorrow.  Although it gets reflected in their future stock prices, the market systematically underestimates this today, making their shares a relative bargain – diamonds in the rough.

– The Mysterious Factor ‘P’: Charlie Munger, Robert Novy-Marx And The Profitability Factor from Forbes (June, 2013)

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