How profitable is profitability?

One of the key factors for finding stocks with high potential is their profitability. There are different ways to assess a company’s profitability and one of these ways is by calculating the ratio of gross profits over total assets. This measure was described in a paper called “The Other Side of Value: The Gross Profitability Premium” by Robert Novy-Marx, from the University of Rochester. How well can this ratio work if we try to do this ourselves, and why would it work, if at all, in identifying good companies to invest in? First, I’ll show the results of investing in the stocks in the S&P 500 index in equal amounts, or equal-weighting, excluding firms in the financial and real estate sectors which together roughly comprise a fifth of the index. This is important because merely and naïvely equal-weighting the index gives dramatically differently results from the normal capitalization method that the index is calculated.

From April 1999 to September 2017, we would’ve had an annualized rate of return of 9.16%.

Now from that same subset, we take only the top 20% of firms, ranked by the ratio of gross profits on total assets.

Here we get an annualized return of 9.95% over the same period.

Now we take the bottom 20% of firms ranked by gross profits on total assets.

We have a return of only 7.31%.

In short, sorting companies by the percentage of their gross profit over their total assets does seem to improve your returns, whether it be by choosing the top quality companies, or at the very least by avoiding the worst ones. While the numbers are compelling, what’s most important is if this strategy actually makes sense and if it could continue to work. In other words, what would be the logical economic explanation for this? I think this can be demonstrated relatively simply by this example of three fictitious companies.

Companies A and B generate the same net income ($3,000) and have the same return on equity (ROE, 15%) and return on assets (ROA, 9%), bottom line ratios that are very common in analyzing stocks. However, the path they took to get to that same end-point was quite different. Company B started off with a much lower gross profit, only $5,000 compared with company A’s $15,000, even though they had the same amount of sales. B’s top-line gross profit as a percentage of total assets is also much lower, 14% vs 43% for A. B spent very little on sales, general and administrative expenses (SG&A) and R&D. Now this could mean that the management of B was extremely careful with its spending, compared to A, but that might not be the case if those expenses are required to run the business well. More importantly, A has a lot more leeway in its spending than B, which started off with less room to maneuver. If the cost of B’s product or service increases, it wouldn’t take much to turn its income negative. Gross profit on total assets gives in this case a better picture of profitability than ROA or ROE.

Another well-used investment metric is the gross profit margin, which is the gross profit divided by the revenue or sales. Again, the picture is incomplete without factoring the capital- or asset-intensity of the product or service being sold. Company C has the same gross margin as Company A, 25%. However, it required twice as much assets to generate those numbers. This translates to a much lower ratio of gross profit to total assets, as well as ROA and ROE. Using this metric shows how A is a potentially superior investment to both B and C. Gross profit on total assets demonstrates that the product is both inherently profitable and requires less investment to generate those similar numbers than the competitors’. While ROA, ROE, and gross profit margin are still factors to consider in investing, I think gross profit on total assets is a logical, superior metric and does a better job at identifying higher quality companies.