You may not know his name now, but you soonwill .
University of Rochester professor Robert Novy-Marx has
developed a new formula, and it has caught the attention ofWall
The Wall Street Journal reports that Greenwich, Conn.-based
AQR Capital is set to launch a set ofinvestment funds based on
Novy-Marx's research, and other investment products geared toward
this approach may soon follow.
Novy-Marx's formula, called the "grossinvesting ratio,"
updates the approach of David Dodd and Benjamin Graham, the
fathers of value investing. And while these investing gurus
countWarren Buffett as one of their disciples, their theories
have lost luster for some in recent decades.
To recap, Dodd, Graham and Buffett preach the merits of investing
in companies with a great trove of assets -- at least in relation
to theirmarket value -- but they also focused onfactors such
asearnings stability and price-to-earnings ratios. For a number
of decades, investors could handilyprofit by following their
But Novy-Marx just may have revealed to investors an important
update to this philosophy that can lead modern investors to
In a nutshell, Novy-Marx likes to see companies with gross
profits worth at least one-third of a company's total assets.
Novy-Marx realized that many investors mistakenly focus on this
year's profits to identify winningstocks . However, growing
companies can be ignored this way, because they must invest
heavily to support future growth. Instead, Novy-Marx suggests you
move up theincome statement : to the gross profits line.
A quick formula:
Gross investing ratio: (gross profits x 3) > total
Let's see how this works out...
I scanned the 1,500 companies in the S&P 600 (small-cap
stocks), S&P 400 (mid-caps) and S&P 500 (large caps ) and
found 85 companies that had a gross investing ratio above 0.33.
Then, I winnowed the group to 66, excluding any company expected
to seerevenue fall from 2013 to 2014. Although he didn't formally
state it, Novy-Marx is only interested in growing companies.
To be sure, it's important to focus on a company'sstock price,
as even a company with impressive gross profits can beovervalued
. So Novy-Marx provides recommends also targeting companies with
a price-to-book ratio below 1.7. This ensures that investors are
essentially paying no more than 1.7 times the value of the
Novy-Marx calls the combination of gross investing and
price-to-book approaches "Quality Investing."
It's an interesting twist. Companies typically without alot of
assets (such as software, biotech or service firms) are likely to
score well on the gross investing measure; however, the
"asset-light" nature of their businesses means they often sport
very high price-to-book ratios. Novy-Marx focuses on firms that
generate impressive gross margins but still trade at reasonable
In his research, he found "pure quality strategies, which buy
the most profitable assets irrespective of price, are roughly as
profitable as traditional value strategies, which buy the
cheapest assets irrespective of quality," henotes . But he adds
that each approach is subject to currentmarket trends, and can
lag if either growth or value investing is out of favor at the
moment. That's why it's wise to combine approaches.
Novy-Marx back-tested his analysis during a nearly 50-year
span and found Quality Investing would have delivered solid
returns with a lot less volatility than a purely growth or value
Here's a look at 10 stocks that have unusually high "gross
investing ratios" and reasonable price-to-book ratios. This means
we're getting the best of both worlds: stocks that are likely to
deliver solid returns with a low degree of volatility.
Here they are...
For investors who insist that value be the primary focus,
let's turn this approach on its head, looking for stocks with the
lowest price-to-book ratios that also have a gross investing
ratio above 0.33.
You'll notice that
Kindred Healthcare (
Amedisys (Nasdaq: AMED)
Lincoln Educational Services (Nasdaq: LINC)
all make the cut using both approaches.
Does that make these stocks a buy? Not necessarily, but they
are worthy of further investment research.
Risks to Consider:
It's crucial to use other financial measures in your
analysis. Certain stocks such as
JC Penney (
make the cut, yet face serious operational challenges these
financial measures fail to capture. JC Penney, for example, has a
gross investing ratio above 0.33, but that figure has worsened in
the past few years.
Action to Take -->
Novy-Marx's approach is fairly simple, yet compelling. We all
love to find value stocks (such as those trading at low
price-to-book values) but would love to avoid low-quality
companies that deserve their low valuations. Conversely, growth
investing involves greater risk when once-great companies hit a
rough patch. A stock trading at reasonable price-to-book value
can soften the blow when the rough patch arrives.
You can use Quality Investing for any stock you analyze. It's
wise to focus on several years of results to determine if a
company's gross ratio is stable and getting stronger. If a
company can meet that target and trade at a reasonable
price-to-book ratio, you likely have a stock that can deliver
long-termupside with less downside.