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A new way to be a value investor?

(MoneyWatch) A recent study could have significant implications for value managers and investors. The study from University of Rochester finance professor Robert Novy-Marx provides investors with new insights into how returns vary across different classes of stocks. The following is a summary of the paper's findings:

  • Profitability, as measured by gross profits-to-assets, has roughly the same power as book-to-market (a value measure) in predicting the cross-section of average returns. It has also been a better predictor than earnings.
  • Surprisingly, profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios (higher price-to-book ratios).
  • Profitable firms tend to be growth firms -- they grow faster. Gross profitability is a powerful predictor of future growth in gross profitability, earnings, free cash flow and payouts.
  • The most profitable firms earn 0.31 percent per month higher average returns than the least profitable firms.
  • The abnormal returns (alpha) of the profitable-minus-unprofitable return spread relative to the Fama-French three-factor model are 0.52 percent per month.
  • High asset turnover primarily drives the high average returns of profitable firms, while high gross margins are the distinguishing characteristic of "good growth" stocks.
  • Controlling for profitability dramatically increases the performance of value strategies, especially among the largest, most liquid stocks. And controlling for book-to-market ratios improves the performance of profitability strategies.
  • While more profitable growth firms tend to be larger than less profitable growth firms, more profitable value firms tend to be smaller than less profitable value firms.
  • Strategies based on gross profitability generate value-like average excess returns, even though they're growth strategies.
  • Because both gross profits-to-assets and book-to-market are highly persistent, turnover of the strategies is relatively low.
  • Similar overall results were found in international markets as well.
  • The data was statistically significant, meaning it's less likely to be a random outcome.
  • Because strategies based on profitability are growth strategies, they provide an excellent hedge for value strategies -- adding profitability on top of a value strategy reduces the strategy's overall volatility.

This last point provides insight into a strategic way to implement a value strategy. The monthly average returns to the profitability and value strategies are 0.31 and 0.41 percent per month, respectively, with standard deviations of 2.94 and 3.27 percent. However, an investor running the two strategies together would almost capture both strategies' returns (0.71 percent per month) with no additional risk (2.89 percent).

As further evidence that the two strategies combine well, consider the following: While both the profitability and value strategies generally performed well over the sample, both had significant periods in which they lost money. Profitability performed poorly from the mid-1970s to the early-1980s and over the middle of the 2000s, while value performed poorly over the 1990s. However, profitability generally performed well in the periods when value performed poorly and vice versa. As a result, the mixed profitability-value strategy never experienced a losing five-year period.

Given these powerful results it will be interesting to see if mutual fund managers and companies will incorporate such findings into their strategies.