Cheap Isn’t Always Good: The Different Between Value and Profits

Tim Melvin  |

One of the most important papers on investing in the past decade was released in the last year, and while professionals have taken note, very little of the information has filtered down to the investing public.

In a recent paper called The Other Side of Value: Good Growth and the Gross Profitability Premium, Robert Novy-Marx of the University of Rochester has shown that the most important manner of measuring profits for individual companies is not what most investors think it is; earnings per share, operating profits and cash flow.

Mr. Novy-Marx found that gross profitability is actually the best way to measure profits

Companies with high gross profits compared to their asset base outperform the market by a wide margin. In fact, these stocks come close to match the performance of stocks trading below book value. In the original study, it seemed that owning stocks below book value as well as these highly profitable companies was the best way for investors to approach the market.

However, the professor followed up the original study with another rune entitled the Quality Dimension of Value. Novy-Marx found that combining the gross profitability and traditional value stocks that traded below book value produced even better returns. In fact, it doubled the outperformance of either strategy on its own. In his conclusion, Novy-Marx noted, “Strategies based on either of value's dimensions generate significant abnormal returns, but the real benefits of value investing accrue to investors that pay attention to both price and quality.

"Attention to quality, especially measured by gross profitability, helps traditional value investors distinguish bargain stocks (i.e., those that are undervalued) from value traps (i.e., those that are cheap for good reasons). Price signals help quality investors avoid good firms that are already fully priced. Trading on both signals brings the double benefit of increasing expected returns while decreasing volatility and draw-downs. Cheap, profitable firms tend to outperform firms that are just cheap or just profitable.

"Quality tends to perform best when traditional value suffers large draw-downs, and vice-versa, so strategies that trade on both signals generate steadier returns than do strategies that trade on quality or price alone.”

As impressive as the returns from the combined strategy are the lack of significant draw-downs during the time period studied, July 1963 to December 2012, contains some horrible market periods including the morass of the 1970s, the 1987 crash, the internet bust as well as the recent unpleasantness of 2008, is even more so. For large cap stocks the combined strategy produced a maximum draw-down of just 13.4 and 18.2 percent. Compare that to what many investors have experienced in the last two bad markets and its clear that in addition to higher returns the strategy offers volatility and price risk.

The combined approach also appears to lessen the uncomfortable periods of underperformance by value stocks

One of the hardest parts of long term asset based value investing is that there can be long periods of underperformance particular in very strong market. Combining price to book value and high gross profits as a percentage of assets with large cap stocks underperforms in just about a third of one year time periods in the study and only 14 percent of the five year periods. The smaller stocks do even better and underperform the market in just over 20 percent of one year periods and an incredible three percent of five year time frames in the 49 year study.

If you run a screen for stocks that fit the bill right now you will find that it is a very short list at the moment as a result of the strong markets of the past few years. ArcelorMittal  (MT) makes the list with the stock trading at just 60 percent of tangible book value. While the steel industry has suffered a deep slowdown along with the global economy the company's assets are just 1.5 times gross profits. When the economy and the steel industry improves and gross profits begin to make their way all the way to the bottom line the stock appears to have significant upside.

SkyWest  (SKYW) also makes the grade with the shares trading at 56 percent of book value and gross profits that are about one half of total assets. The company operates regional airlines branded as Delta Connection, United Express, US Airways Express, American Eagle, and Alaska Air under code-share arrangements. The stock has done very well over the past year but is still cheap on the combined measurements.

In all, only 20 US-listed companies make the grade so the value set among large caps under this measurement is fading. However, the study has given value investors another valuable tool to use when looking for cheap stocks that have high recovery potential.

Tim Melvin is a value investor, money manager and writer. He has spent the last 27 years as in the financial services and investment industry as a broker, adviser and portfolio manager. He has also written and lectured extensively on the markets with his work appearing on, DailySpeculation.Com as well as several print publication including Active Trader and the Wall Street Digest. You can learn how Tim invests in low risk; high yield stocks by clicking here and watching his FREE webinar now.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:

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