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Ignore earnings: a fresh (and profitable) approach to picking quality stocks

Tuesday, March 19, 2013

SCOTT BARLOW

sbarlow@globeandmail.com

Some phrases in investing are used so often they largely cease to have meaning. High-quality stocks is one of them.

Most professional investors boast they hold a portfolio of high-quality stocks. But ask them what this means and their response is either often a glassy-eyed stare or a vague nod to strong management and large profits at the companies they have selected.

Robert Novy-Marx, a professor of finance at the University of Rochester offers a fresh take on how to look at quality from an investing perspective. His suggestion - to look at a company's ability to sell things for a lot more than it costs to make them - is simple, yet appears remarkably robust.

If nothing else, his take on quality could finally end the financial world's confusing use of the term. Canadian car buyers are well aware that quality is primarily a question of reliability - it means a car will do what it's supposed to do and not break. An Italian supercar that goes 250 kilometres an hour but spends half the year in a mechanic's garage is not a high-quality car, it's merely fast. Yet in investing, quality is most often confused with unsustainable profits or earnings growth based on factors beyond management control. (I'm looking at you, resource sector).

Prof. Novy-Marx's measure of quality - which consists of subtracting the total cost of the goods sold by a company from its total revenue, and dividing the result by the firm's total assets - is simple as financial ratios go. But, according to an article to be published in the Journal of Financial Economics, it has generated investment returns that exceed more complicated techniques used by Wall Street professionals.

"While analysts spend a lot of time thinking about bottom line earnings ... gross profitability, which appears almost at the top of the income statement, is a much better predictor of a firm's future stock performance," he writes.

How much better? He calculates that a strategy of buying the 150 large-capitalization U.S. stocks with the highest gross-profit-to-assets ratio, and refreshing this selection once a year, would have turned one dollar invested in 1963 into $241 by 2011 - more than triple the benchmark return.

One reason that high-quality stocks do so well is that the characteristic, as defined by Prof. Novy-Marx, tends to persist." The highest-quality stocks tend to remain the highest-quality stocks so fewer trades are necessary and transaction costs remain low.

Another reason is that focusing on the top lines of the income statement rather than on the bottom line tends to avoid a lot of the accounting jiu-jitsu that can obscure the financial health of a company.

The Wall Street Journal's Jason Zweig cites Amazon.com Inc. as an example of a company with an especially high gross-profit-to-assets ratio. Many investors are mystified by Amazon's high-flying stock price, which ticks in at a lofty 175 times earnings.

But, Mr. Zweig notes, Amazon's gross profitability goes a long way to explaining the stock's value. While Amazon's bottom-line earnings are depressed by the company's enormous research and development efforts, it has demonstrated an impressive ability to generate high gross profit in relation to its assets.

As always, it's dangerous to pick stocks based on a single metric. But the gross-profit-to-assets ratio is an important conceptual tool. It demonstrates that quality doesn't have to be a subjective factor: it can be measured empirically in a way that has generated returns.

How should you use it? One idea is to seek high-quality stocks trading at relatively low valuations by traditional measures, such as price to book value and price to earnings. Prof. Novy-Marx's research suggests that the best results come from combining quality with value.

For now, you may want to watch to see how this new approach works out. Three U.S. stocks that currently score well in terms of gross profits to assets are Wal-Mart Stores Inc. , General Electric Co. and Ford Motor Co.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.