Background to the study

In this 2013 study, researchers analyzed the relationship between corporate gross profitability, measured as the ratio of value added (sales minus cost of goods sold) to assets, and average stock returns. This methodology departs from conventional approaches that focus on the book-to-market (B/M) ratio to predict returns. The study used cross-regressions, a statistical technique, to examine company returns as a function of gross profitability, while controlling for other factors such as company size and B/M ratio.

Study results

The results of the study are revealing. Profitable companies generate significantly higher returns than unprofitable companies, even though they have higher valuation ratios. By integrating gross profitability into value strategies, performance improves considerably, especially for the most liquid stocks. These findings are difficult to reconcile with popular explanations of the value premium, as profitable companies are less prone to financial distress, have longer cash flow durations and exhibit lower levels of operating leverage. Furthermore, controlling gross profitability explains most earnings anomalies and a wide range of seemingly unrelated trading strategies. The study demonstrates that strategies based on gross profitability, while being growth strategies, provide an excellent hedge for value strategies and reduce the overall volatility of a value portfolio.

Contributions of the study to the field of stock market investing

This study brings a fresh perspective to stock market investing, highlighting the importance of gross profitability as a performance indicator. Investors can now consider adjusting their value strategies by integrating gross profitability to improve returns and reduce risk. Strategies that combine value-based stock selection with gross profitability filters appear to offer a better set of investment opportunities. In practice, investors should consider building portfolios that favor companies with a high ratio of gross profits to assets, while taking into account their market valuation. This could involve selecting shares in companies that not only appear undervalued, but also demonstrate an ability to generate high profits relative to their assets.

"The other side of value: The gross profitability premium" suggests that investors should reassess traditional value strategies and consider gross profitability as a key predictor of stock market returns. This approach could lead to more informed and potentially more profitable investment decisions in the financial markets.

Bonus:

As examples, I add to this study a few global companies that currently boast high gross return on assets and low valuations:

  • Lennar Corporation
  • Hartford Financial Services
  • Toll Brothers
  • Chevron Corporation
  • Janus Henderson Group
  • Stellantis
  • Tenaris
  • Hoegh Autolinears
  • Betsson
  • Saint-Gobain

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