In 1934, Ben Graham advocated buying stocks at a steep discount to their intrinsic value, giving birth to “value investing.” It wasn’t until forty-three years later that academics confirmed the durable long-term outperformance of value stocks. In the interim, Warren Buffett — who took Graham’s class at Columbia in 1951 — saw the approach had merit and used it to become a billionaire. [Disclosure: I am long Berkshire Hathaway (BRK.A). You can carve that one into my tombstone.]
Berkshire Vice-Chairman Charlie Munger is widely credited with expanding Buffett’s investment opportunity set from the garbage pail of unloved, undervalued stocks to the wonderful world of quality companies at fair prices. American Express (AMEX) and Coca-Cola (KO) were prime examples. Quality + Value then became the two pillars supporting Berkshire Hathaway’s entirely satisfactory long-term performance.
Berkshire’s $44 billion acquisition of Burlington Northern Santa Fe is a more recent example. Ben Stein and I were in Warren’s office the week the deal was announced (we even brought him a 1937 Lionel train catalog in case he wanted to buy more). He freely admitted that Burlington Northern wasn’t a value play at the price/earnings ratio he paid. What he relished was an opportunity to deploy billions of dollars of Berkshire’s cash hoard purchasing a high-quality long-term asset. Burlington Northern possessed a significant “moat.” Try starting a transcontinental railroad and you’ll see what I mean.
Fifty-four years after the first Munger/Buffett confab, academics have confirmed the intuition behind Munger’s “Quality” pillar. The researcher this time is Berkeley-trained financial economist Robert Novy-Marx, now an assistant professor at the University of Rochester and a fellow at the National Bureau of Economic Research.
Looking at NYSE firms between 1963 and 2010 and international firms between 1990 and 2009 (ex-financials), Novy-Marx discovered that a company’s gross profitability did as good a job at predicting its future returns as conventional value metrics like book-to-market. More profitable companies today tend to be more profitable companies tomorrow. Although it gets reflected in their future stock prices, the market systematically underestimates this today, making their shares a relative bargain – diamonds in the rough.
Gross profitability is defined as the ratio of a firm’s gross profits (income minus cost of goods sold) to its assets. Wait a minute, you object: this leaves out half the income statement. What about all the expenditures — shouldn’t we take these into account to determine the business’s true intrinsic profitability?
The answer is “no,” and that insight was Novy-Marx’s genius. By definition, the best investments today will be the most profitable firms of tomorrow, but how can we find them without using a time machine? Gross profitability looks like a good proxy. The further down the income statement we go, the more the mind becomes clouded by Jedi accounting tricks that occlude rather than reveal true value, until finally the bottom-line ‘net’ profitability becomes completely useless as a predictor. The top line is the bottom line.
Firms with a high level of top-line profitability possess stunningly productive assets. What happens in these situations is that eventually, on average, management gets out of the way and they become manifest. By screening out the stocks with less profitable assets (stocks that will prove to be expensive in the long run), we effectively pay a low price today for the remaining stocks with the more profitable assets. This makes quality investing a variation of the value strategy.
It gets better. These profitable companies tend to be larger and sell at higher book-to-market multiples than traditional value stocks. Even though they are different flavors of value, their fortunes are uncorrelated. When you combine them in a single portfolio, you get higher expected returns for the same level of risk (or, depending on how you want to play it, the same returns for less risk). Novy-Marx found that while a dollar invested in the market in July 1973 grew to over $80 by the end of 2011, that same dollar invested in value + profitable stocks grew to $572 (before frictional expenses).
The quality screen means you don’t buy the cheap value stocks that are cheap because they are bad, and the value screen means you don’t overpay for the quality stocks that are expensive. This is why brainiac mutual fund companies like AQR Capital and Dimensional Fund Advisors are beavering away applying the new quality metric to their funds, and Novy-Marx has been given the key to the City of Quantville.
I recently had an opportunity to pepper Professor Novy-Marx with a few questions:
Q. Profitability seems like an obvious fundamental metric.
Profitability does indeed seem like an obvious determinant of future stock performance, and has for a long time. Benjamin Graham wrote as much about firm quality as he did about stock price—but we identify him purely with “traditional” value strategies (i.e., price-based) because his value metrics work while his quality metrics don’t.
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