In 2012, Novy-Marx published the paper “The Other Side of Value: The Gross Profitability Premium”. The study showed that profitability (as measured by gross profits-to-assets) can be usefully employed to outperform the market.

Novy-Marx also found that this measure negatively correlates with traditional value measures. This was a helpful finding as it means the out-performance of profitability is coming from ‘growth’ stocks rather than ‘value’ stocks, as you might expect.

Therefore, by combining both value and profitability we should be able to create a strategy which significantly improves the performance of a value strategy alone.

Let’s see if it does.

The criteria for the strategy we have created is as follows:
Exclude Financial stocks
Exclude over-the-counter stocks
Rank all companies by their gross profits to asset ratio – highest to lowest (i.e. descending)
Rank all companies by size – large to small (i.e. descending)
Combine the two ranks above and re-rank the total – selecting in a descending order

Buy stocks with a…
– stock price greater than 1
– gross profits to assets ratio greater than or equal to 55%
– price to sales ratio of less than or equal to 1

Sell stocks if…
– the gross profits to assets ratio falls below 35%
– the company’s price to sales ratio is greater than or equal to 6