Adding Quality to the Value Mix

 | May 12, 2014 | 2:30 PM EDT
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One of the advantages of being a geek is that all the reading eventually leads to new discoveries. Last year, I stumbled upon the work of Professor Robert Novy-Marx from the Simon Graduate School of Business at the University of Rochester. In a paper titled "The Other Side of Value: The Gross Profitability Premium," released in June 2012, he demonstrated that companies that earned a high rate of gross profits compared with total assets outperformed the market by a pretty wide margin.

In fact, over time, this approach to picking stocks has worked as well as the other noted value anomalies, such as book to market. He further found that when his finding is combined with a value approach, you get a higher return with less overall risk, as the two strategies are not correlated and tend to move in different directions, on the basis of various market and economic factors.

I cobbled together a screen that identifies stocks that have high gross profits when compared with the asset base used to produce the profit. The list includes some interesting names, and long-term buy-and-hold investors who have a preference for high-quality stocks might want to consider owning them. Even value types who are uncomfortable having their entire portfolio in small, unknown, cheap stocks might want to consider adding some of the higher-quality stocks, as Novey Marx indicates that this may dampen volatility somewhat.

If we use Novy-Marx's definitions, CBOE (CBOE) is one stock that fits the profile of a high-quality stock. The company operates the Chicago Board Options Exchange, the best-known listed options exchange, as well as electronic platforms for the trading of futures and options. Higher trading volume helped the company post record results in the first quarter, and volatility futures and options trading continue to increase as investors look to trade volatility and use it as a hedge. Over the past 12 months, the company has produced gross profits of $587 million, and total assets are just $12 million, so it actually produced more in gross profits each year than its total assets, so it definitely qualifies as a high-quality stock.

Jones Lang Lasalle (JLL) provides commercial real estate and investment management services worldwide. The company recently posted a solid first-quarter report, and CEO Colin Dyer told investors, "Solid first-quarter revenue and profits produced a good start to 2014 for JLL. The broad strength of our business globally and improved client confidence in market conditions point to another year of healthy growth for the firm." The company is producing its results in a very efficient manner, as it has trailing 12 months gross profits of $4.4 billion, and total assets are just $4.5 billion. Commercial real estate has not seen the same surge of institutional buying as residential, and there is still a lot of upside in most regions of the country. This company should benefit from that eventual recovery.

One of my favorite companies made the grade as well. My wife and I both like to target-shoot, and we are big fans of Smith & Wesson Holding (SWHC). The company makes handguns, including revolvers and pistols, and long guns, such as sporting, bolt-action and single-shot rifles. The company has seen strong profit growth the past few years, as the ongoing conversation about gun control has served as a powerful marketing tool for firearms manufactures. I will leave the politics for others to discuss, but people have rushed to purchase firearms over the past few years, and this trend has been fantastic for business at Smith & Wesson. The company earned gross profits of $257 million, and total assets are just $346 million, so it makes the grade as quality company.

I cherry-picked the list a bit in order to highlight companies that make the grade and seem to have some demographic and economic trends to push them higher over time. Some of the bigger, better-known names that make the grade as high-quality stocks are Wal-Mart (WMT), Phillip Morris International (PM), PepsiCo (PEP) and MasterCard (MA). Novey-Marx has produced research that clearly shows that adding a high-quality component to your portfolio can lead to higher returns and possibly even reduce overall risk. Long-term investors should be aware of the potential benefits of this approach.

The professor didn't stop there. In 2013, he produced another paper that defined a way to use this methodology to supercharge long-term returns. Tomorrow we will look at that strategy and at some of the stocks that qualify for this new approach.

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