March 02, 2013 / By Jason Zweig, WSJ
Believe it or not, there could be a new holy grail for investors.
"Great ideas come along maybe once every 20 years or so," David Booth, chairman of Dimensional Fund Advisors in Austin, Texas, which manages more than $262 billion, told me this week.
Lately, he and other leading investors have gotten excited about a financial measure called "gross profitability" or "quality." The measure appears to identify companies that will earn even more money in the future. New funds are launching based partly on it. What should you know before you consider joining in?
Research to be published soon in the prestigious Journal of Financial Economics by Robert Novy-Marx, a finance professor at the University of Rochester, shows that bargain-priced "quality" stocks outperformed the overall market by more than four percentage points annually between 1963 and 2011. This stunning margin is even higher than that earned over the same period by traditionally measured cheap "value" stocks, but usually with less severe losses in market downturns. Quality also tends to do well when value does poorly—and vice versa.
"There's something there, and I don't think it can be ignored," says William Bernstein, a money manager and investment theorist at Efficient Frontier Advisors in Eastford, Conn. "We don't know exactly why it works, but it works."
Most investors zero in on the bottom line: a company's net earnings. But here, it is what is near the top line that matters: total revenues minus basic expenses. When a company's goods and services take in a lot more money than they cost to produce, that is a high gross profit margin—and a strong signal of quality.
"You get much more informative signals about the health of firms" this way, Mr. Novy-Marx says.
That partly is because many of the investments that companies make for their long-term future growth can result in short-term hits to reported net earnings. A firm that spends on research and development, for example, is seeking to bolster its future profits by ensuring that it won't run out of new products to sell. That spending rise will hurt this year's net earnings. But the quality measure doesn't penalize companies for spending on R&D—and thus might be more effective at identifying tomorrow's more profitable firms today.
Over the past four quarters, for instance, Amazon.com AMZN +2.80% generated $61.1 billion in revenues. Its cost of goods sold, or basic expenses, amounted to $44.3 billion, leaving gross profits of $16.8 billion on total assets of $32.6 billion. But, largely because the company spent nearly $14 billion on R&D and marketing, its reported net income was negative $39 million.
Focus only on net earnings and you might miss the massive investment Amazon is making in its future—which could well pay off in years to come. Remember that the quality measure is designed to capture this kind of raw profitability. (Amazon didn't respond to a request for comment.)
As Warren Buffett has long shown with his stock picks, if investors underappreciate how much a company is likely to grow in the future, it can turn out to be a bargain even if it looks somewhat pricey by conventional measures.
Cliff Asness, managing principal at AQR Capital Management, a firm in Greenwich, Conn., that runs more than $71 billion and is launching funds that use the factor, says taking account of quality is "a great way to make a more accurate value measure."
Fund companies have noticed. Last December, Dimensional Fund Advisors introduced four funds that combine quality with pricier "growth" stocks. Later this month, AQR is expected to start three funds that blend quality, cheap "value" and fast-moving "momentum" stocks. As for annual expenses, the DFA funds will charge 0.2% to 0.55%; AQR's haven't been disclosed yet.
Funds or ETFs investing purely on the basis of quality can't be far behind, say industry analysts, although none are available yet.
Picking stocks this way isn't something you could pull off on a weekend morning in your pajamas. For each potential investment, you would need to subtract the company's cost of goods sold from its revenue, then divide by its total assets.
In general, says Mr. Novy-Marx, you want that ratio to be 0.33 or higher. You then would look for a low price-to-book-value ratio, available on most financial websites—ideally 1.7 or below. You would have to stick to big companies and diversify across many industries and dozens of stocks.
There's no rush. Let the funds launch and get seasoned. See whether the managers can deliver. Then wait some more, sitting out the inevitable boom in popularity. Before long, investors will be complaining that quality is overrated and that other investing styles work better.
Mark my words: At that point you will be able to get quality in quantity.