Quality Factors

Gross Profitability

More than 50 years ago, Charlie told me it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain-hunting, with results ranging from tolerable to terrible.

Warren Buffett in Letter to shareholders 2012

Robert Novy-Marx, a professor at the University of Rochester, discovered that gross profitability - a quality factor - has as much power to predict stock returns as traditional value metrics. He found that while other quality measures had some predictive power, especially on small caps and in conjunction with value measures, gross profitability generates significant excess returns as a stand-alone strategy, especially on large-cap stocks.

Gross Profitability is calculated as follows:

Gross Profitability = ( Total Revenue - Cost of Goods Sold ) Total Assets

Novy-Marx's key insight was that you don't need to go further down the income statement as these numbers may get manipulated with accounting tricks. To identify profitable firms, one should look at the top line, not the bottom line.

In one of his papers, Novy-Marx compares gross profitability to the other most famous strategies such as the Greenblatt magic formula, Piortoski F-Score, etc. You can read more about it here. You can also read an interview with Mr Novy-Marx here.