Spinning Gold Into Straw

 | Oct 30, 2013 | 4:30 PM EDT
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I have spent a lot of time recently on the ideas of Robert Novy-Marx, the University of Rochester professor who has advanced some theories on combining profitability with value characteristics in an effort to find stocks that can outperform the markets. He has some interesting ideas, and I find in testing and twisting his ideas that they work -- and are now in my tool box.

When you use a ratio of gross profit to assets, you can spot companies for which the market does not clearly see the potential for large profits. If you then apply classic value characteristics to the analysis, you filter out stocks that can provide huge returns. This constitutes some of the more groundbreaking equity market research of the past couple of decades, in my opinion.

Of course, since it's me, I have to try and take the data and see how else we can use this to profit or protect our assets. Berkshire Hathaway's (BRK.A) Charlie Munger stole the idea from the mathematician Carl Jacobi, and I stole it from him -- but the concept of "invert, always invert" has always made sense to me. In this case I will take it to mean that, if something works in one direction, then it should not work in the other. Can we look for companies that trade well above book value and use too many assets to provide too small a profit, and thus find stocks that we should avoid or even short, if that's your kind of thing?

I sat down and ran a screen to find exactly those characteristics. The first observation is going to require some more digging and twisting on my part but, at first glance, big banks use an enormous amount of assets to produce relatively minor profits. At the moment, so do large-cap real estate investment trusts, as the enormous asset base these REITs own is not producing a heck of a lot of top-line profit. The leveraged business model of both sectors almost prevents them from ever making the profitable-and-cheap portfolio.

One company that makes the list has seen its stock bounce nicely in the past month as investors have speculated on a mining-and-metals recovery. I own some mining stocks, but Freeport-McMoRan (FCX) is thankfully not one of them. The company is using a stockpile of more than $60 billion in assets, and it has produced less than $6 billion in gross profit from that hoard. In addition, unlike some of the other miners I have picked up in recent months, Freeport stock is not particularly cheap: It trades at about 2x book value.

Nucor (NUE) is another stock that has been rallying, yet fails to make the grade as a cheaply priced, profitable company. The steel concern has shown some signs of life recently, and analysts are expecting strong results from it in 2014. However, Nucor is currently using more than $15 billion in assets to produce just $1.4 billion in gross profit over the past year. The stock is fetching more than 2x book value and more than 30x trailing earnings right now, so there are no measures you could use to call the stock cheap, either.

Service Corp. (SCI) also scores very poorly on this screen. This company owns about 1,500 funeral homes and close to 400 cemeteries around the U.S., and is viewed as an almost utility-like business for its ability to generate consistent cash flow to service debt. While it is true that we are all going to eventually need this company's services, or those of a competitor, it takes an enormous amount of assets for Service Corp. to generate profit.

Specifically, this firm has assets of more than $10 billion, yet it's generating just about $550 million in gross profit. That works out to less than a 6% gross yield before such niceties and interest, taxes, salaries and other necessities. The stock trades at almost 3x book, and tangible book is pretty much negligible due to all the acquisitions the firm has made over the years. It may be a business that will always be with us, but the stock is not cheap at this point, and the company is not wildly profitable either.

It is clear to me that Professors Novy-Marx's theories have enormous value for asset-based value investing. I am also highly confident that, with the exception of a few quantitative analysts, most folks will ignore it, or will use it with price-to-earnings ratios and P/E-to-growth ratios. As a result, it seems likely that this analysis will continue to have value for many years to come.



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