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.
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)