Can this University Professor's New Formula Help You Beat the Street?

StreetAuthority Network

You may not know his name now, but you soon will.

University of Rochester professor Robert Novy-Marx has developed a new formula, and it has caught the attention of Wall Street.

The Wall Street Journal reports that Greenwich, Conn.-based AQR Capital is set to launch a set of investment funds based on Novy-Marx's research, and other investment products geared toward this approach may soon follow.

Novy-Marx's formula, called the "gross investing ratio," updates the approach of David Dodd and Benjamin Graham, the fathers of value investing. And while these investing gurus count Warren 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 their market value -- but they also focused on factors such as earnings stability and price-to-earnings ratios. For a number of decades, investors could handily profit by following their simple rules.

But Novy-Marx just may have revealed to investors an important update to this philosophy that can lead modern investors to market-beating gains.

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 winning stocks. However, growing companies can be ignored this way, because they must invest heavily to support future growth. Instead, Novy-Marx suggests you move up the income statement: to the gross profits line.

A quick formula:

Gross investing ratio: (gross profits x 3) > total assets.

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 see revenue 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's stock price, as even a company with impressive gross profits can be overvalued. 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 company's assets.

Novy-Marx calls the combination of gross investing and price-to-book approaches "Quality Investing."

It's an interesting twist. Companies typically without a lot 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 values.

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," he notes. But he adds that each approach is subject to current market 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 approach.

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...

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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.

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You'll notice that Kindred Healthcare (KND), Zale (ZLC), Amedisys (AMED) and Lincoln Educational Services (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 (JCP) and GameStop (GME) 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-term upside with less downside.

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