A Cheap and Profitable Screen

 | Sep 13, 2013 | 3:00 PM EDT  | Comments
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Stock quotes in this article:

mt

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rsh

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apol

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coco

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ceco

I reviewed the recent academic work of Robert Novy-Marx on Thursday. In his paper, "The Other Side of Value: Good Growth and the Gross Profitability Premium," the University of Rochester professor looked at historical returns from stocks with very high levels of gross profitability, and he found that they performed as well as stocks trading at a low price-to-book value. Combining the two types of stocks in your portfolio outperformed the market. Novy-Marx went even deeper and found that if you buy stocks below book value that also have high levels of gross profitability, you produce a portfolio of super-value stocks that consistently beat the market.

Being a bit of a skeptic, I conducted some quick back tests of his theory and found huge excessive returns. In the last year alone the big-cap, value-profitable stocks returned 45% while the small-cap stocks in the portfolio were up 54%. That is impressive performance, so I quickly built a screen that looked for cheap stocks that have very high gross profits compared to their asset base.

I found some surprises when I ran the screen. Some companies you might not think of as wildly profitable actually are when you measure them by gross profitability. Keep in mind that gross profitability is simply total sales minus cost of goods sold and leaves out all the overhead and other expenses. Novy-Marx found that this was the best measure of profitability and it has strong predicative value. So this the one we will use.

Arcelor Mittal (MT) is a large integrated steel company that one would not necessarily think of as wildly profitable as it has struggled in recent years. It took a bottom line loss in 2012 but managed to paint the bottom line black in the preceding decade. The CEO recently told investors that he believed the company had turned the corner and should see better conditions in the steel market in 2014. When we measure it in terms of gross profitability compared to assets, we find that the company has assets of $112 billion and gross profits over the last four quarters have been a little more than $74 billion. That is one of the cheapest ratios on the deep-value, high-profits screen. The stock is certainly cheap, trading at less than 60% of tangible book value.

I almost feel out of my chair I when saw RadioShack (RSH) on the list of cheap high-profit stocks. This has been a dog the past few years, and I was much too early buying it in anticipation of a turnaround or takeover. The company has its issues, but it also has a very high level of gross profitability with $1.4 billion of gross profits in the past year on an asset base of $1.9 billion. The stock is still cheap at 78% of book value, so if the company can find a way to improve the items between gross profits and the bottom line, my patience may yet be rewarded.

I was surprised that even though my credit and fundamental models use a lot more than one factor, the gross profitability and book-value combination picked out many companies I have mentioned on Real Money and own for myself, as well as for family and friends. Stocks including Kimball International (KBALB), Xyratex (XRTX), RealNetworks (RNWK) and SkyWest (SKYW) have very high gross profits as a percentage of assets. Trans World Entertainment (TWMC) is one of the stocks I hate to love as I believe brick-and-mortar music and video stores are an industry on the way out, but the stock has high gross profits as a percentage of assets and trades at just 85% of book value.

So do a couple of companies I have had my eye on but haven't purchased yet. Tropicana Entertainment is Carl Icahn's casino purchased out of bankruptcy a few years ago. It operates casinos in Nevada, Indiana, Louisiana, Mississippi, and New Jersey, as well as one in Aruba. The stock may not do much until Icahn decides to sell or otherwise transform the company, but it trades at just 3x gross profits and 80% of tangible book value.

I have not been a fan of the for-profit education business model, and Apollo Group (APOL) is one of the best shorts I have ever put on in my life. But many of the stocks in the group, such as Corinthian Colleges (COCO) and Career Education (CECO), are trading below book value and have high gross profits compared to assets. I haven't bought in yet, but the valuation is becoming compelling.

Using gross profits as a measure of profitability is clearly effective and should be an arrow in every investor's analytical quiver. When used with value stocks, it works extremely well at locating stocks that can survive and eventually thrive.

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