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How to Find High Quality Stocks

March 04, 2013
Greenbackd

Greenbackd

32 followers
Robert Novy-Marx, whose The Other Side of Value paper we quoted from extensively in Quantitative Value, has produced another ripping paper called The Quality Dimension of Value Investing (.pdf). Novy-Marx argues that value investment strategies that seek high quality stocks are “nearly as profitable as traditional value strategies based on price signals alone.”
Accounting for both dimensions by trading on combined quality and price signals yields dramatic performance improvements over traditional value strategies. Accounting for quality also yields significant performance improvements for investors trading momentum as well as value.
Novy-Marx’s The Other Side of Value paper showed that a simple quality metric, gross profits-to-assets, has roughly as much power predicting the relative performance of different stocks as tried-and-true value measures like book-to-price.

Buying profitable firms and selling unprofitable firms, where profitability is measured by the difference between a firm’s total revenues and the costs of the goods or services it sells, yields a significant gross profitability premium.
Most intriguingly, Novy-Marx finds that “the signal in gross profits-to-assets is negatively correlated with that in valuation ratios.”

High quality firms tend to trade at premium prices, so value strategies that trade on quality signals (i.e., quality strategies) hold very different stocks than value strategies that trade on price signals. Quality strategies tilt towards what would traditionally be considered growth stocks. This makes quality strategies particularly attractive to traditional value investors, because quality strategies, in addition to delivering significant returns, provide a hedge to value exposures.
Novy-Marx argues that investors can “directly combine the quality and value signals and, in line with Graham’s basic vision, only buy high quality stocks at bargain prices. By trading on a single joint profitability and value signal, an investor can effectively capture the entirety of both premiums.

Performance of Quality, Value and Joint Strategies

(Click to enlarge).

novy-marx-2-1.jpg?w=500&h=655

Drawdowns to Quality, Value, and Joint strategies

(Click to enlarge).

novy-marx-2-2.jpg?w=500&h=669

Importantly, the signal in gross profitability is “extremely persistent,” and works well in the large cap universe.

Profitability strategies thus have low turnover, and can be implemented using liquid stocks with large capacities.
Novy-Marx’s basic message is that investors, in general but especially traditional value investors, leave money on the table when they ignore the quality dimension of value.

Read The Quality Dimension of Value Investing (.pdf).

Tomorrow, I show in an extract from Quantitative Value how we independently tested gross-profits-on-total-assets and found it to be highly predictive.

About the author:

Greenbackd
Greenbackd is a former corporate advisory and securities lawyer working in value-oriented activist funds management.

Rating: 2.9/5 (7 votes)

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