The following article appeared in the 1 April 2013 issue of the Quant Value Investor newsletter.
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Does business quality give you better returns?
Do you think that the quality of a business makes any difference in terms of returns compared to only buying undervalued companies?
It doesn’t but we may have found a quality ratio that helps.
As you know our experience testing quality ratios in our book Quantitative Value Investing In Europe: What Works for Achieving Alpha has been mixed.
It doesn’t work
Return on invested capital and return on assets as a single factors weren’t good predictors of future returns.
Even though high quality companies did do better than junk companies using both ratios the results were not linear and choosing only high quality companies would not have helped you to consistently outperform the market.
A better quality ratio?
In a very interesting paper we stumbled on recently called The Quality Dimension of Value Investing (click on the name to go to the paper) Robert Novy-Marx defined a quality ratio that according to his tests does lead to better results.
How is it calculated
Robert defined a quality company as one that had a high gross income ratio which is calculated by dividing gross profits by total assets.
Whereas gross profit is calculated as sales minus cost of sales and assets is simply total assets as shown in the company’s balance sheet.
In the paper Robert shows that this simple ratio has about the same predictive power as other valuation ratios such as price to book for example.
Does it work?
We of course wanted to test if it was a good single factor to use. And our year back test (on European companies) came up with the following result:
2 Compound annual growth rate
As you can see the results are (apart from Q1 to Q2) nearly linear. And companies with a high quality ratio did substantially better than companies with low ratio.
The STOXX Europe 600 index over the same period had a compound annual growth rate of -0,82%, worse than even the worse quintile, most likely because of the banks being included in the index and because the index is market weighted.
Better than ROA & ROIC
This is thus a much better quality factor you can use compared to either return on assets or return on invested capital
We are not convinced
Because of our unconvincing experience with other quality ratios we are not yet completely convinced by the gross income ratio.
We worry that it may be selectively mining data (looking for a ratio that worked over a specific period but that may not work in future) and would like to test it further.
This is what we think of quality ratios at the moment.
High quality companies may not make you rich but if you buy low quality companies you have a good chance of becoming poor.
If it works you will see it
You can however be sure that if we find the gross income ratio valuable (after further testing) it will be included in the investment model we use to select ideas for the Quant Value newsletter.