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September 18, 2019

The Gross Profitability Trap

Derek Bergen, CFA and John Holt, CFA

“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.

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.

Executive Summary:

  • 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.

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