Quality and profitability factors

Cheapness is not the only signal researchers found priced into future returns. A separate line of research asked whether more profitable, safer and faster-growing companies also outperformed, independent of how cheap they were, and found that they did.

Profit, measured near the top of the statement

Novy-Marx defined gross profitability as gross profit, meaning revenue minus the cost of the goods sold to earn it, divided by total assets. He argued this measure predicts returns about as well as book-to-market does. It also sits closer to the top of the income statement, before selling costs, research and advertising, which Novy-Marx argued often build the business while cutting reported earnings. A company can look far more or less profitable by net income than it does by gross profitability, depending on how it spends and depreciates, without its underlying business having changed at all.

Profitable firms look expensive

Novy-Marx found that profitable firms earned higher returns than unprofitable ones, despite having significantly higher valuation ratios. Adding profitability to a value sort improved it further, especially among the largest, most liquid stocks. Profitability and cheapness are pulling in different directions on price: the market pays up for a profitable business, and the research finds that it still does not pay up enough.

Safe, profitable, growing and rewarding shareholders

Asness, Frazzini and Pedersen built a broader quality score around four traits: profitability, growth in that profitability, safety measured by low beta, low volatility and low leverage, and a payout policy that returns capital rather than diluting shareholders. They found that high-quality stocks did cost more on average, but not by much. Perhaps for that reason, a portfolio that owned quality stocks and sold junk stocks short earned significant risk-adjusted returns, in the US and across 24 countries.

Quality and cheapness are different tests

A cheap stock says nothing about whether the underlying business is profitable, safe or growing, and a high-quality business says nothing about whether its price already reflects that quality. Combining the two raises the bar on both at once, which is one reason the top-left quadrant above, high quality and still cheap, turns up less often than either quadrant on its own. A screen can test both conditions at once, but doing so shrinks the list, since every added condition can only hold it steady or narrow it.

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