Traders have long sought the perfect recipe for making money in the stock market, but so far no such formula has been discovered… or has it?
Lately, a new way to measure companies has gained a lot of popularity. The measure, referred to as “gross profitability” or “quality”, aims to isolate companies that will increase their earnings in the future.
Traditionally, investors have used corporate earnings as the best way to judge a companies business, but those who believe in the “gross profitability” method argue that this is no longer the best way to predict a company's future.
The basic premise behind this new strategy is to examine what is taking place near the company's top line. It suggests that traders look at total revenues minus the company's basic expenses. When sales far exceed the costs needed to produce those sales, it results in a high gross margin, and this is the best indicator of future profitability.
A perfect example of why this methodology makes sense can be seen in companies that spend heavily on research and development. When a company invests heavily in its future, those expenses get counted against revenues, and thus can result in disappointing earnings.
This can be seen as a negative by investors who focus on earnings, but not by those who opt to go with “gross profitability” measures. This is because research and development expenses are not even taken into consideration.
The Journal of Financial Economics will be releasing a report soon that shows these “quality” stocks would have outperformed the overall market by more than 4% between the 1963 and 2011.
While it sounds like a good way to improve performance, it is not a simple measure to make. In order to give a company an accurate measure you need to take total revenue, and subtract cost of goods sold, and then divide by the company's total assets. Once you reach this calculation you want to look for company's with a ratio greater than 0.33. In addition, you want a price-to-book value ratio under 1.7.
It is not an easy system to integrate into your daily trading, but the good news is that Wall Street is paying attention, and we are seeing funds starting that use this measure as they method of picking stocks.
So far most of the funds that have started to use the metric are doing so in conjuction with other methods, but analysts expect that we will soon see mutual funds or ETFs appear that invest purely on the basis of quality.
Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.