A New Look At Profitability

12/2/2013


Analysts have been studying the U.S. stock market for more than 100 years, and over time a lot of us have plowed the same ground. So when a fresh, creative analysis tool pops up, we take notice.

A 2012 study by University of Rochester professor Robert Novy-Marx offered a new take on profitability. While a number of academic studies in recent decades have indicated that profitability metrics have little power to predict stock returns, Novy-Marx tackled the issue from a new angle and found just the opposite.

According to the 2012 study, which considered monthly returns for U.S. stocks from 1963 through 2010, stocks in the top quintile (one-fifth) as measured by gross profit/assets delivered value-weighted monthly excess returns of 0.62% (7.7% annualized), twice the bottom quintile's return of 0.31% (3.8% annualized). Excess returns reflect returns above the risk-free rate generated by short-term Treasury securities.

The gross profit/assets ratio, which Novy-Marx calls gross profitability, works even better in concert with the price/book ratio, one of several valuation metrics considered by our Quadrix Value score. Gross profitability can separate the weak from the strong even among the low-valuation stocks that as a whole average higher returns than more expensive stocks.

Gross profitability offers several advantages over traditional profitability metrics, including:

• The gross profitability ratio avoids the accounting issues inherent in operating and net income that have little impact on future profitability. The further you go down the income statement, the more management discretion (such as spending on marketing or administrative salaries) and noncash costs (such as depreciation or amortization) can distort the pure profit-generating potential of a firm's assets. Gross profit is near the top of the income statement, representing sales minus the cost to produce goods.

• Many companies lose money at the net- or operating-income level, but most do post positive gross profits, which allows for the clean comparison of more companies.

• The study suggests that shares of the most profitable companies are no more volatile than those of the least profitable. Investors can rarely earn higher returns without accepting higher risk.

• Gross profit — and the gross profitability ratio — tend to be steadier than metrics that rely on operating or net profit, which suggests investors can have more confidence in a company's ability to repeat the performance.

We're adding gross profitability to our Quadrix stock-rating system, where it will fit into the Quality category. The Quality score already uses three profitability measures — return on equity, return on investment, and return on assets — that consider net income rather than gross income. Gross profitability should provide a useful counterpoint.

The table below lists eight recommended stocks with gross profitability ratios above historical, sector, and industry norms. All also score well for Quadrix Value, Quality, and Overall. Three are reviewed below:

Like star-crossed lovers, DirecTV ($65; DTV) and Dish Network ($53; DISH) keep batting eyes at each other, with the CEOs of both companies espousing the virtues of a merger — if only regulators would allow such a thing. Comcast ($50; CMCSa) is reportedly testing the regulatory waters with a possible big deal of its own, which could open things up for DirecTV and Dish. A deal could help the companies contain soaring content costs in an industry that has begun to shrink. The U.S. pay-TV industry shed 113,000 subscribers in the September quarter, up from 101,000 lost in the year-ago quarter, according to an industry researcher. DirecTV bucked that trend by adding 139,000 net subscribers in the most recent quarter.

Despite the challenging backdrop, DirecTV has generated higher gross profits in 36 consecutive quarters and appears on pace to deliver its seventh year of higher return on assets in the past eight years. DirecTV also scores above 95 for both Quality and Value, the only S&P 500 stock to do so. DirecTV is a Focus List Buy and a Long-Term Buy.


Kroger ($43; KR) has delivered record gross profits in 13 consecutive quarters. Looking ahead, the consensus anticipates healthy growth for the food retailer, projected to post 11% growth in the year ending January 2015. October-quarter results are due Dec. 5. However, Kroger faces several potential headwinds. The reduction in food stamps could force the grocery-store chain to lower its prices, while health insurance costs from the Affordable Care Act threaten to cut into household budgets.

But the stock trades at just 15 times trailing earnings, 29% below the median for S&P 1500 food retailers. Kroger also scores above 80 in Quadrix for the price/sales, price/cash flow, and enterprise ratios — the three most effective Quadrix factors for S&P 500 stocks in the past 10 years. Kroger, earning a Value rank of 79, is a Focus List Buy and a Long-Term Buy.


Qualcomm ($72; QCOM) sees smartphone shipments growing at a 20% annualized rate through 2017, driven by emerging markets. Low-end smartphones could jump 50% in 2014, compared to 8% growth for premium devices. That could put more pressure on Qualcomm's gross profit margins, down in three consecutive quarters, though the company has fattened operating profit margins in three of the last four quarters.

In a change of strategy, management says it may take on debt to fund acquisitions and capital returns (dividends and share buybacks). Qualcomm's long-term debt has steadily declined in the past 10 quarters and currently totals just $17 million, versus nearly $15 billion, or more than $8 per share, in cash. Through dividends and stock buybacks, Qualcomm aims to return 75% of free cash flow to investors over the next five years, up from 62% returned in the past five years. Free cash flow jumped 81% to $5.68 billion in the 12 months ended September. The stock, also reviewed in Portfolio Review, is a Focus List Buy and a Long-Term Buy.

On the web

For a list of all S&P 1500 Index stocks with gross profitability above historical, sector, and industry averages, visit www.DowTheory.com/Go/GrossProf.

STOCKS WITH HIGH GROSS PROFITABILITY
An academic study found that gross profitability (gross profit divided by assets) has predictive power, with more profitable stocks outperforming the less profitable. This profitability ratio works even better in concert with price/book, a popular valuation metric. The eight recommended stocks below all boast gross profitability above historical, sector, and industry averages and score in the top one-third of our research universe in Quadrix Value, Quality, and Overall. Gross profitability is being added to our list of Quadrix variables in the Quality category.
--------- Gross Profit Divided By Assets ---------
------ Quadrix Scores ------
Company (Price; Ticker)
Last 12
Months
(%)
1 Yr.
Ago
(%)
3 Yrs.
Ago
(%)
Sector
Average
(%)
Industry
Average
(%)
Value
Quality
Overall
Sector
Industry
Bed Bath & Beyond
($78; BBBY)
73.2
66.2
62.8
52.1
62.2
83
96
95
Cons. Discret.
Specialty Stores
Continental Resources
($110; CLR)
23.8
19.1
23.3
17.2
15.6
70
99
99
Energy
Exploration & Prod.
DirecTV ($65; DTV)
72.0
68.6
62.0
52.1
37.6
96
97
98
Cons. Discret.
Cable TV
Dover ($92; DOV)
34.7
34.7
32.9
32.1
33.4
68
83
83
Industrials
Machinery
Helmerich & Payne
($77; HP)
24.5
24.5
18.8
17.2
17.6
79
91
98
Energy
Oil & Gas Drilling
Kroger ($43; KR)
82.9
81.1
77.2
45.5
75.1
79
86
94
Cons. Staples
Food Retail
Qualcomm
($72; QCOM)
35.9
30.0
27.3
35.8
32.9
80
96
98
Technology
Telecom Equipment
Skyworks Solutions
($27; SWKS)
36.1
34.7
32.2
35.8
35.4
94
92
99
Technology
Semiconductors
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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