In his study "The Other Side of Value," Professor Robert Novy-Marx of the University of Rochester found that picking stocks based on gross profitability as a measure of quality performed as well as traditional value measures. He also found that adding quality to a value portfolio improved performance.
He said in his conclusions that, "Adding a profitability strategy on top of an existing value strategy actually reduces overall portfolio volatility, despite doubling the investor's exposure to risky assets. Value investors should consequently pay close attention to gross profitability when selecting their portfolio holdings, because controlling for profitability dramatically increases the performance of value strategies."
Novy-Marx combined gross profitability with price to book value and found that the combination supercharged stock returns and reduced drawdowns. While I like that approach, I have crunched a bunch of numbers with this strategy and found that with large-cap stocks, if we swap out book value for enterprise value to earnings before interest and taxes (EV/EBIT), we get slightly better performance, and so that's the large-cap quality value bucket I am using in the Grand Unified Investment Theory portfolio.
When I screened for large-cap stocks with high gross profitability, I looked for companies where assets are less than 4x gross profits and I cut off EV/EBIT measure at 8, as that is about half of the median measure of S&P 500 components right now. I find that right now there are not many that qualify, but the ones I did find are intriguing long-term investments.
The cheapest large-cap quality stock is Franklin Resources (BEN). The mutual fund giant has been hit by fund outflow all year, and competition from exchange-traded funds has hurt most of the big mutual fund companies. Franklin has been hit particularly hard in recent months with a 5.7% decline in assets under management in September. Some of its biggest income funds have been underperforming and investors are pulling back from equity funds in general, so the firm is struggling a bit right now.
The stock is cheap with an EV/EBIT ratio of just 4.2. There is hidden value in the company, and a recent Barron's article estimated that the real estate, investments and cash held by the company could be worth almost $18 a share, short of the current $38 and change stock price. The stock yields 1.7% and management has a strong track record of increasing the payout and declaring special dividends. They have also been buying back stock, and that could slow the decline in the stock price. Gross profits are almost 33% of total assets, so in addition to being cheap, it is a quality stock.
With an EV/EBIT ratio of 7 and gross profits that are 67% of total assets Bed, Bath and Beyond (BBBY) makes the grade as a high-quality, cheap, large-cap stock. The stock fell after missing analyst estimates for revenue on the prior quarter and earnings were slightly ahead of last year at a $1.20 a share compared to $1.17. Business may not be booming, but I can tell you that as long as my wife and adult kids are alive, the retailer will be fine. I do my part to support the stock, as its World Market chain is one of the best places around to find reasonably priced wine. The stock is a solid, long-term, quality large-cap pick at a good price.
All the legacy airlines make the grade as quality cheap stocks. American Airlines (AAL), United Continental (UAL) and Delta (DAL) all have gross profits that are high as a percentage of total assets and trade at lower-than-market EV/EBIT ratios. All the airlines are enjoying the benefits of lower fuel prices and have learned to manage their operations to ensure more flights leave the gate full. While I am not a great fan of that as a passenger, it's pretty good for profit margins. Airlines should do even better as the global economy continues to slowly improve and demand picks up. The legacy carriers are getting better at competing on price, too, as my flight to Chicago for tonight's Cubs game was cheapest on United.
The large-cap quality value bucket of our portfolio has historically not returned quite as much as deep value, but it is a more consistent performer with lower drawdowns. That can lower volatility and actually improving long-term returns.