Value Investing Forum

From the article (footnote 3 on page 11):

Book-to-market is book equity scaled by market equity, where market equity is lagged six months to
avoid taking unintentional positions in momentum. Book equity is shareholder equity, plus deferred taxes,
minus preferred stock, when available.

I think including intangibles is pretty standard in all of the academic literature on book to market stuff. So it's basically just the inverse of the standard price to book.(I'm actually curious how the "book to market" convention got started in the academic literature and why most investors look at Price to book… but that's just one of my odd curiosities.)

Cliffnotes version:

Gross profitability (GP) as meausred by gross profits / assets is a good predictor of stock returns in the same way that book to market (BM) is a good predictor of stock returns.

1) Past research had difficulty finding a relationship between earnings and stock returns. Gross profit, the author claims, is a better indicator of economic force since things get muddy down the income statement. For example, depreciation is at the discretion of management, interest and taxes are dependent upon capital structure and credit ratings, things like R&D will lower current period earnings but have a trickling effect into future periods, etc.

2) High GP firms tend to, on average, have low BM (often referred to as "growth").

3) High GP firms provide higher risk adjusted returns (in terms of Fama's model) so I guess Fama will have to say that high gross profitability is a risk factor. (While we're on the subject, I suppose high Piotroski score is also a risk factor.)

4) Stocks which have both qualities (High GP and High BM) will have magnified returns.

5) The author groups stocks into quintiles of GP and BM and you can find stocks that are in every category (if you put them into a 5x5 matrix)

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So I did a look at the DOW 30 (minus 4 financials), here are top tens.

Gross Profitability Rankings (with GP):

1) WMT – 63%

2) MSFT – 61%

3) HD – 58%

4) INTC – 52%

5) MMM – 46%

6) IBM – 45%

7) JNJ – 44%

8) PG – 34%

9) MCD – 34%

10) CSCO – 34%

Book to Market Rankings (with GP):

1) AA – 10%

2) GE – 12%

3) KFT – 20%

4) T – 26%

5) CSCO – 34%

6) PFE – 28%

7) HPQ – 27%

8) DIS – 12%

9) CVX – 23%

10) MRK – 33%

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The only company in the top 10 of both lists is CSCO (MRK was 11th on the GP list). Many of the firms that were on the high BM ranking were low on the GP ranking. For example, AA and GE were 1 and 2 on the BM list, but 26 and 25 on the GP list. Granted, many of the high GP firms are selling at low multiples of other ratios (like P/E).

There were three stocks that were in the bottom 10 of both lists: BA (21%) CAT (23%) and DD (24%).

I found this on the recent article on Greenbackd:
An examination of the "Profit and Value" strategy

There's an interesting looking paper (I haven't read it yet) that the blog discusses which I found a pdf on:
The Other Side of Value: Good Growth and the Gross Profitability Premium

The ratio looked at is Gross Profits / Assets.