The gross profit ratio tends to favor growth firms but is not identical to identifying growth firms on the basis of standard metrics. The author examines using a ratio of gross profit (revenue less cost of goods sold) to assets as a means of creating and enhancing long–short portfolio strategies. He finds that the gross profit long–short strategy (long very profitable firms and short less profitable firms) hedges value strategies effectively and enhances a number of other strategies as well.
What’s Inside?
The author constructs long–short portfolios on the basis of a ratio of gross profit (revenue minus the cost of goods sold) to assets and finds that the strategy performs better than a typical growth strategy. The gross profit strategy tends to use growth stocks but in a more optimal way than standard growth strategy metrics. Because the gross profit strategy is growth oriented, it is a very good hedge for value strategies. Between July 1963 and December 2010 (the sample period), a combined strategy of gross profit and value never generated a losing five-year return.
In addition, the author constructs long–short portfolios on the basis of a double sort of the three Fama–French factors and a measure for momentum with gross profitability. The procedure takes long positions in stocks that are desirable with respect to the given factor and high in gross profitability and short positions in stocks that are not desirable with respect to the given factor and low in gross profitability. In each case, gross profitability adds a significant economic dimension to the strategy.
Finally, the inclusion of gross profitability with standard explanatory factors for stock returns improves the explanation of excess returns generated by a number of long–short strategies based on anomalies.
How Is This Research Useful to Practitioners?
By incorporating gross profit in a given strategy, practitioners can improve their long–short strategies. Previous research had dismissed profitability as a metric, but the author demonstrates that profitability (generally measured with earnings in the past) may have been misspecified and possibly misinterpreted because previous testing has been dominated by data from many smaller firms, which have not constituted the majority of the capitalization of the market.
On a more basic premise, it makes intuitive sense that gross profit should matter because it measures the effectiveness of the basic business plan before a number of other factors are considered when calculating earnings. Gross profit is certainly related to a firm’s categorization as a growth firm, but as the author points out, gross profit seems to be a means of finding the better firms within the growth firms.
Furthermore, when combining gross profit with a value strategy, the performance results over the past few decades are difficult to ignore.
How Did the Author Conduct This Research?
The accounting data are from Compustat from July 1963 to December 2010; most firms included are NYSE/Amex firms (financial firms are excluded). The return data are monthly.
Much of the analysis requires separating firms into groups on the basis of the ratio of gross profit to assets and, in many cases, another factor (Fama–French factors and momentum). When sorted, returns within groups are tested to determine whether return differences are statistically significant. The long–short portfolios are rebalanced annually; returns are regressed against a number of factors to determine whether excess return can be produced and to determine what factors may explain some of the long–short portfolio return.
Finally, the author tests 15 different anomaly strategies by regressing the given anomaly-generated return against explanatory factors that have gross profit incorporated. A shorter time series (July 1973–December 2010) is used in this analysis.
Abstractor’s Viewpoint
I like the idea of gross profit being valuable in explaining return from an intuitive perspective, and as demonstrated by the author, it makes sense from an empirical perspective. But I think the really valuable contribution is how a gross profit strategy can be used to hedge a value strategy.