The Gross Profitability Trap
“But this time, it’s different!” More foolish words are rarely spoken in the financial industry, but they always seem to find their way back into the stock market lexicon. A firm’s intrinsic value should always be a function of discounted future cash flows that incorporate a comprehensive understanding of profitability, growth, competition, and risk. Occasionally, alternative approaches can find favor in enough market participants’ stock selection to distort the foundational understanding of firm value.
History has proven that, at certain times, speculatively reckless and risk-seeking investment styles become so commonplace that they distort overall market returns. Disciplined investors with long-term investment horizons initially struggle as they lag broader market benchmarks as a new approach better explains recent performance. If these themes persist long enough, it is eventually amplified by momentum strategies or other trend-following investors. To be clear, there is always a place for objective speculation; new entrants can offer an enticing long-term vision of a revolutionary product or breakthrough while they are early stage businesses focused on R&D and growth, but numerous roadblocks and pitfalls are possible for these high-growth startups and significant due diligence is crucial. Investors who are good stewards of capital will balance long-term future growth and potential profitability against competition and risk to formulate a thesis around a sound estimate of intrinsic value.
When these new themes dominate long enough, an existential crisis for the disciplined manager develops. Is everything we know about investing wrong? Are these recent themes the “new normal”, and should we reposition our portfolios to align with these recent trends? Or do we have confidence that our research process is not the culprit and position our portfolio to exploit mispricing from a crowded trade as recent trends that distort firm value, understate competition, and misrepresent risk unwind. The tech bubble scenario of this is well-documented, as “new economy” language dominated the justification of absurd market prices, and it appears that a similar trend of justifying allocation towards risky, expensive investments has expanded over the last several years and crept into broader stock selection as well.
This write-up will attempt to understand recent market trends through the lens of Gross Profitability. It appears that enough investors now view Gross Profitability as a viable proxy to future firm profitability that it has temporarily, and likely in a very short-sighted manner, replaced a more robust approach to valuation in stock selection. Ironically this metric, which claims to be the “other side of value”, does not have a link to firm value at all and should not be used as a stock selection criteria on a stand-alone basis. As this variable has gained popularity over the last few years, AFG’s research has noted the dominance of growth over value, momentum over valuation, and market-cap weighted indices over equal-weighted alternatives, but it seems that these trends are all explained by the expanding application of Gross Profitability in stock selection since its introduction several years ago. Broader industry discussion has become sensationalized as “Value is Dead!”, but managers need to realize that it simply lays dormant as this misguided proxy for valuation encourages the reckless bidding up of select growth stocks. Make no mistake: the tech bubble’s application of a distorted valuation approach led to a sudden and painful snap back for trend-followers without a valuation discipline, so investors should exercise caution trading this theme today.
Gross Profitability: Introduction
The Gross Profitability Trap – “The Other Side of Value” Traps
When portfolio managers screen for relative value using price multiples, it is assumed that they become susceptible to a “value trap” without a quality or momentum overlay. Can Gross Profitability suffer from a similar fallibility? Portfolio managers favoring stocks with high levels of Gross Profitability as a proxy for high future earnings are susceptible to a “Gross Profitability trap” without a valuation overlay. Examination of the current marketplace shows signs that a bias towards expensive stocks with high Gross Profits has distorted market prices on select individual securities by a significant level over the last several years, which could lead to large potential capital losses on a forward-looking basis for expensive high Gross Profitability firms as market prices correct for this misrepresentation of risky future earnings.
• Gross Profitability offers intriguing risk-adjusted characteristics as a quality metric useful in stock selection.
• Gross Profitability works best in tandem with a valuation metric over long-term time horizons, since its construction does not have an embedded valuation discipline on a stand-alone basis.
• Recent US trends highlight that a valuation overlay is likely disregarded by many market participants, and Gross Profitability could be the culprit behind excessive risk-taking in speculative investments since 2017, especially in health and technology sectors.
• Examination of high Gross Profitability firms with poor valuation characteristics highlights the recent significance and persistence of this bias, likely further fueled as price discovery characteristics of the market are muted by ongoing shift towards passive investment, as well as the limited float of earlier stage health/tech investments.
• Careful examination of this data should serve as a meaningful reminder on the inherent risks embedded into high profitability stocks with poor valuation characteristics and encourage market participants to establish a valuation discipline in tandem with this robust profitability screen.
The Gross Profitability premium, defined by Robert Novy-Marx (2013, Journal of Financial Economics) simply as Revenue minus COGS divided by Total Assets, has found substantial following in the factor model, hedge fund, and quantitative investment landscape in the short time horizon since its original publication. Gross Profitability is assumed to be a strong predictor of a firm’s future earnings, and analysis of the variable over long-term time horizons certainly delivers attractive results.
Reviewing this data in aggregate since 1998, top quintile stocks within each sector have outperformed their bottom quintile peers by almost 9.0% on an annualized basis alongside attractive risk-adjusted returns and modest turnover characteristics. These results are compelling, and it is clear why equity managers would include this robust metric in their stock selection criteria. It is important to note, however, that a stock with gross margins of 80% and asset turns of 1.25 will have a Gross Profitability measure of 100% ($100 in Revenue – $20 COGS / $80 in Assets), and will likely screen well on this measure regardless of whether they trade at $50/share or $5,000/share. This should be a material detail in practice, otherwise a concentrated focus on this metric by a large number of investors would lead to rampant mispricing on speculation of future earnings completely disconnected from current market value.
Gross Profitability & Valuation
Novy-Marx researched Gross Profitability in tandem with Book to Price ratios as a source of relative value, discovered that Gross Profitability is negatively correlated to Book to Price, and labeled this metric as the “other side of value”. In other words, Book to Price strategies exploit mispricing by selling expensive assets to purchase cheap assets, while profitability strategies sell unproductive assets to purchase productive assets. Novy-Marx sees profitability as another way to understand firm value in addition to Book to Price, but pointed towards the use of both approaches in tandem due to their negative correlation. Without a robust valuation discipline, Gross Profitability is best considered a quality metric; a higher level of Gross Profits is certainly a sign of high quality, including less likely financial distress and lower operating leverage concerns.
The performance data below highlights the effectiveness of combining Gross Profitability with Book to Price, where the combination of top quintiles return 14.9% while the combination of bottom quintiles return only 0.6% per year. It is important to note that relative value multiples are far from ideal in formulating a comprehensive valuation thesis on a stock, and Book to Price also tends to be the worst performing relative value option. The relationship of these variables also have a really strong inversion: A-graded book to price stocks are more likely to be F-graded from a Gross Profitability perspective, and A-graded Gross Profitability firms are more likely to be F-graded book to price firms based on count analysis.
Gross Profitability and Book to Price
Two additional observations are critical here. First, the performance of Book to Price on a stand-alone basis is underwhelming, where top quintile stocks only outperform bottom quintile stocks by 1.9% per year, compared to 8.9% spreads for Gross Profitability. We can certainly improve upon this research by using a more robust valuation metric in AFG’s Percent to Target – Current metric. Second, based on the widely-accepted basis of Novy-Marx’s research, it could be deemed rational for market participants to place outsized preference on Gross Profitability instead of Book to Price given the relative strength of each metric, but doing so could encourage overpaying for high Gross Profitability firms if an underlying valuation relationship is ignored.
Gross Profitability and AFG Intrinsic Value:
The Novy-Marx research clearly offers a compelling metric to consider in multifactor model development, but the use of Book to Price for the value input focuses on “value” as a style classification, which is not a meaningful proxy for valuation. AFG’s Economic Margin framework is built around a market-oriented model that focuses on profitability, growth, competition, and risk to articulate a comprehensive estimate of intrinsic value. Through AFG’s valuation lens, style classifications are less meaningful, since growth is simply an input into the estimate of a firm’s intrinsic value. Rebuilding Novy-Marx’s analysis to compare AFG’s Percent to Target – Current metric to Gross Profitability incorporates a much more robust valuation metric, which also creates a much more compelling multifactor model.
Top Quintile and Bottom Quintile spreads for AFG’s approach to valuation improve to 9.7%, compared to 1.9% for book to price. The top quintile interaction for each metric improves to 17.8%, outperforming the combination of bottom quintile stocks by nearly 18.5%. These AA/FF quintile spreads improve by more than 400 bps per year over the Book to Price version above. Over longterm time horizons, the combination of Gross Profitability with a well-constructed valuation metric provides compelling evidence for stock selection application. The relationship between these two metrics is also much more normal, as counts across each of the crossed quintiles are fairly constant compared to the clustering observed in the Book to Price dataset.
Gross Profitability: Performance Regimes
Gross Profitability & Intrinsic Value Regimes
Closer examination of the interaction of Gross Profitability and Percent to Target over time yields interesting results. This write-up will focus on the rise and collapse of the tech bubble, the long-term “normal” through the end of 2016, as well as recent trends since the start of 2017. These themes are important to understand in both broad universe and large cap analysis to ensure too much emphasis is not placed on small-cap/micro-cap trends, and additional insight is found by examining performance in technology and health care sectors where seasons of irrational speculation can abnormally influence returns in a much more significant manner. AFG has live production data and Russell constituents as of 9/30/98; we can use this start date to analyze performance through the rise of the tech bubble as of the end of February 2000.
Rise of Tech Bubble: September 30, 1998 to February 29, 2000
Over this brief window before the collapse of the tech bubble in early March 2000, it is clear that Gross Profitability was not a relevant theme in broad market returns. A focus on technology and health care stocks actually highlights a preference towards low Gross Profitability firms, which likely reflects investor preference towards hardware and equipment instead of software, human capital and R&D that better defines recent high flyers in these sectors. The tech bubble behavioral issues are well-documented, and it is clear that high levels of Gross Profitability did not help explain the broad market trends during the late 90s as much as a preference towards stocks with limited or negative cash flow today but unmeasurable future opportunities through the lens of the “new economy”. What in early stages may have indeed been rational in that regard was quickly replaced with reckless investing styles that ignored a disciplined approach rooted in intrinsic value.
Tech Bubble Collapse: February 29, 2000 to December 31, 2002
This roughly three-year horizon following the crash of the tech bubble provides a cautionary tale of overly-speculative investor behavior distorting market prices and the ensuing impact on market performance as themes stabilize towards longterm normal levels. Stocks with poor valuation characteristics continued to become increasingly expensive over the rise of the tech bubble, and their eventual decline was significant, especially in health and technology sectors. Stocks with attractive valuation characteristics in the broad market, on the other hand, actually appreciated over the course of the tech bubble collapse, while attractively-valued health and technology stocks sold off much less sharply than their expensive peers. This example is extreme, but it is important to acknowledge that a short-term distortion or ignorance towards valuation is typically followed by significant performance reversals as rational investment resumes at some point. When this occurs, trend followers will experience significant underperformance in their portfolios.
Long-Term “Normal”: December 31, 2002 to December 31, 2016
Long-term, the combination of Gross Profitability and AFG’s Percent to Target – Current metric has performed extraordinarily well in the Russell 3000, with 12.6% annualized spreads between the AA and FF baskets from the recovery following the tech collapse through the end of 2016. Over this longer-term analysis, both Percent to Target – Current and Gross Profitability deliver robust, monotonic returns on a stand-alone basis in the Russell 3000 universe. These returns are muted in Russell 1000 analysis, where Gross Profitability appears best suited to provide insights as an exclusionary metric on the lowest quintile, while the remaining four quintiles deliver similar levels of performance to each other. AFG’s intrinsic value estimates, on the other hand, continued to deliver robust returns in the large cap space over this much longer time horizon.
Setting the Gross Profitability Trap: December 31, 2016 to June 30, 2019
The last several years share more similarities with the late 90s tech bubble than any other period over the last two decades. Since the start of 2017, we have observed a similar (but much milder) aversion to valuation that was noted during the tech bubble, but this time we see a much stronger preference towards high Gross Profitability firms. It is clear that health and technology stocks are a significant driver of this recent Gross Profitability appetite, where early stage growth companies are likely to have minimal COGS and small tangible asset bases while they are still in the midst of heavy R&D investment. Broader market spreads of Gross Profitability quintiles are roughly 6% between A and F-graded baskets, and these spreads increase to 16% in the Russell 3000 and 14% in the Russell 1000 when we focus solely on technology and health care stocks.
When adding a disciplined valuation overlay to Gross Profits, it is shocking that the basket of highest quintile Gross Profitability firms (A-graded) with bottom quintile valuation characteristics (F-graded) have appreciated by nearly 40% per year in both the Russell 1000 and Russell 3000 technology and health care sectors since 2017. Bidding up expensive stocks in this manner is reckless, and it is the sign of a crowded trade around this Gross Profitability measure completely disconnected from any rational valuation-based discipline. It is crucial for investment managers to fully understand this recent distortion in investor preference. Gross Profitability may certainly be a proxy for future earnings and future earnings are a proxy for future cash flows, which is a material input into a comprehensive and reliable intrinsic value estimate, but “proxying” a proxy leaves much to be desired as a comprehensive investment thesis. It appears that rapid adoption of this metric by active managers has unwittingly led to the encouragement or justification of risky behavior, and market performance observed following the collapse of the tech bubble should provide encouragement to make sure a valuation discipline is embedded in your investment process on a forward-looking basis.
Gross Profitability: Understanding the Market Impact
Based on the previous regime analysis, it is clear that investors have become much more willing to assume excessive risk in the last several years compared to any point since the collapse of the tech bubble. At first, this shift may have been based on rational insight. Tax reform at the end of 2017 would lead to significant cash repatriation by large multinational corporations, creating opportunities to acquire young firms with proprietary intellectual capital but limited revenue streams. Interest rates have been historically low, providing significant time frames for companies to grow before eventually becoming profitable and returning cash to investors. At the same time, the performance of Gross Profitability as a stock selection tool offers robust risk-adjusted returns, so its application in an investment process is certainly reasonable. While recent regime analysis highlights that screening for high Gross Profits increasingly ignored valuation principles, this was likely further amplified by momentum and trend-following strategies at the same time price discovery was muted by the rise of passive investing. Combined with high levels of restricted shares and low float, it is certainly possible that it only took a few market participants to crowd this trade and distort market prices for small-cap stocks in the health and technology space.
Current market prices achieved for many of these highly speculative long-term “disrupters” can begin to make a little more sense through this lens, especially the 40+% annualized returns for health and technology stocks in the Russell 3000 that offered high Gross Profit levels yet poor valuation characteristics. But it is also clear that this trend has not been limited to small cap health and technology, so we can further understand the persistence of this theme by analyzing a much larger cap stock that was not likely an M&A target outside of the health and technology sectors.
Nike Inc. (NKE) – High Gross Profitability & Recent Market Price Impact
NKE delivered Gross Profits of 14.5B on its most recent annual report at the end of 2016 (labeled 2015 using AFG’s Fiscal Year convention, based on May 2016 fiscal year end). Scaling as a percentage of total assets, which were 21.4B, Gross Profitability measured 67.6%, which fell in the 80th percentile of the Consumer Discretionary sector. NKE is capital light, with most of its corporate assets focused on marketing, and tends to rely on low cost manufacturing outside of the United States, and its sector rank has hovered around this 80th-percentile level for the last several years.
Nike closed 2016 with a $50.83 market price. Since then, very little has changed operationally outside of realizing a lower corporate tax rate following US tax reform, which is already reflected in recent intrinsic value estimates. Operating income growth and asset growth since 2015 have been mild, and AFG’s default estimate of intrinsic value has been stable around $53/share. AFG’s default model for Nike also has a significant degree of historical accuracy. Despite this, Nike had appreciated nearly 70% by early July 2019 despite limited operational changes. This divergence from intrinsic value was gradual: at the start of 2017, NKE appeared mildly attractive at the 61st percentile level in the Consumer Discretionary sector. Since then, we have seen NKE’s relationship between intrinsic value and market prices deteriorate – by the end of 2017, the sector rank of its Percent to Target metric had fallen to the 39th percentile; by the end of 2018, it had fallen to the 30th percentile, and by the end of June, it has fallen to the 25th percentile in the Russell 3000 Consumer Discretionary sector. At its current price, the market implies NKE can continuing growing sales at 7-8%/year through 2022 and expand EBITDA Margins by nearly 3% over the next five years to 17.25%. This is unlikely, as EBITDA Margins have averaged 14.7% for NKE since 2000, with an all-time high level of 16.7% over the last 18 years.
Gross Profitability: Assessing the Market Impact
Investor preference towards Gross Profitability untethered to valuation can influence market prices in several material ways. Growth managers can use what appears to be sound quantitative reasoning to apply this metric to their stock selection process and justify bidding up already expensive stocks. The following table highlights Russell 3000 health/tech stocks with at least $1B market cap on 12/31/16 with top half Gross Profitability ranks and poor intrinsic value sector ranks that further appreciated at least 100% through June 2019. At this point, the revenue growth and EBITDA Margin expansion required to justify market prices for most of these stocks are absurd. These are significant Gross Profitability traps, since a mild shift in this market theme by a few larger active managers could put significant downward pressure on their market prices. At the same time, liquidity could disappear and impact broader equity markets similar to the hedge fund deleveraging event in 2007, since a large number of growth funds primarily focus on these types of investments in their equity allocation.
Significant Gross Profitability Traps: Expensive Health and Technology Stocks, 12/31/2016
Mild Gross Profitability Traps: Recent Valuation Deterioration Despite High Accuracy
The second market distortion relates to the bidding up of market prices of attractively valued, high accuracy stocks, similar to the previous Nike example. Despite long-term track records of high accuracy, valuation has deteriorated for these stocks as investors began to support higher market prices based on attractive levels of Gross Profitability. The following table is ranked by the decline in Percent to Target Sector Rank data since the end of 2016. These are milder Gross Profitability traps that have performed well over the last several years due to their alignment with this Gross Profit preference, but would likely lag broader markets as investors revert towards a more robust definition of firm value.
Gross Profitability: Conclusion
The adoption of Gross Profitability as a stock selection tool since its initial publication in 2013 is a fascinating case study, due to the rapid material shift in investor preference that it has inspired over the last several years. As investors perform further due diligence on this metric, it should become more widely adopted that a valuation overlay is critical to ensure long-term strategy success. In the meantime, however, early application with minimal valuation influence has likely encouraged risky investor behavior that echoes themes of the tech bubble, albeit at a slower pace with milder returns and generally isolated to stocks that screen well on a specific attribute.
•Current shareholders of expensive, high Gross Profitability stocks should consider realizing gains before these stocks lag the market on a forward-looking basis.
•Instead of chasing performance, managers should identify attractively-valued stocks that also screen well on a Gross Profitability basis, especially in the Technology and Health Care sectors, to better align with current investor preference, while also focusing on process-driven performance goals rooted in valuation.
•This biased misrepresentation of firm value using “future earnings potential” could persist indefinitely, since changes in irrational behavior are impossible to forecast, but rising interest rates could impact the extremely long time horizons granted to early-stage growth companies.
•Unlike the tech bubble, the distortion at this point is isolated to a relatively small universe of stocks, and its aggregate impact appears to be most influential in the smaller cap technology, health care, and growth universes, based on the Russell 2000 Percent to Target median charts to the right. On a large cap basis, we observe median Percent to Target levels still reflect “normal” valuation levels relative to long-term averages in the Russell 1000.
•To further assist with navigating this trend, the tables below provide a short list of health care and technology stocks that provide attractive characteristics from AFG’s Percent to Target and Gross Profitability lenses.