In Robert Norvy-Marx’s paper The Other Side Of Value: The Gross Profitability Premium, the link between value and quality is explored. Specifically, Norvy-Marx finds that business with a higher gross profit to assets ratio (GP/A) perform significantly better than those with a low GP/A ratio.
Intuitively, this makes sense. A business that can earn high margins should have a strong competitive advantage in place to be able to resist market forces and charge such a high premium. Highly profitable businesses should make more money for shareholders than low profitability businesses, all other things being equal.
Value & GP/A
The value effect is well documented in academia and by practitioners such as Walter Schloss, Benjamin Graham, and Seth Klarman. The idea is very simple. Businesses that trade at a lower multiple to their book value or earnings value will perform better than businesses that trade at higher multiples. It is one of the two most profitable ‘market anomalies’ discovered (the other being momentum). Interestingly, the GP/A ratio is just as valuable as the Price to Book ratio.
“Profitability, as measured by the ratio of a firm’s gross profits (revenues minus costof goods sold) to its assets, has roughly the same power as book-to-market predicting the cross-section of average returns.”
Even better, the GP/A ratio is complimentary to the value effect. Generally, traditional value stocks are low quality (that’s why they are cheap). Combining value and GP/A finds higher quality businesses trading at lower prices.
Dividend Aristocrats, Value, and GP/A
Businesses with higher GP/A tend to do better than businesses with lower GP/A. Businesses with lower P/B or P/E tend to do better than businesses with higher P/B or P/E. Interestingly, Dividend Aristocrats have outperformed as well, and are generally viewed as relatively safe stocks due to their 25+ years of consecutive dividend increases. The list below shows the Top 10 non financial Dividend Aristocrats that have the best rank of Value as measured by their P/E ratios, and profitability as measured by their GP/A ratios. You can download the complete spreadsheet here.
- Wal-Mart (WMT)
- Cintas (CTAS)
- W.W. Grainger (GWW)
- Genuine Parts Company (GPC)
- C.R. Bard (BCR)
- Clorox (CLX)
- ExxonMobil (XOM)
- PepsiCo (PEP)
- 3M (MMM)
- Johnson & Johnson (JNJ)
Combining Growth with Value & Gross Profitability
Of the 10 stocks listed above, PepsiCo, W.W. Grainger, and Wal-Mart have the highest growth rates. Combining growth with quality, value, and dividends provides a ‘best of all worlds’ portfolio of reasonably cheap, reasonably high quality, and reasonably fast growing businesses. PepsiCo, W.W. Grainger, and Wal-Mart will be examined below.
PepsiCo’s high gross margins come from its iconic brands. The Doritos, Cheetos, Lays, Gatorade, Pepsi, Mountain Dew, 7 Up, Quaker Oats, and Tropicana brands all belong to the business. Pepsi has a long history of profitable growth. The company has paid increasing dividends for 42 consecutive years. Such a long streak is due to the relative stability of the food and beverage industry in which the company operates.
PepsiCo’s second quarter results were positive. The company grew organic revenues in all of its 4 divisions versus the same quarter last year.
- PepsiCo Americas Food organic revenue growth of 4%
- PepsiCo Americas Beverage organic revenue growth of 1%
- Europe organic revenue growth of 5%
- Asia, Middle East, & Africa organic revenue growth (AMEA) of 7%
As can be seen from the company’s recent results, revenue is growing quickest internationally, especially in emerging markets. PepsiCo’s future growth will come increasingly from the developing world as the company achieves greater market share with its well known brands.
Wal-Mart Current Events
Similarly to PepsiCo, Wal-Mart has a long history of consecutive increases. The company has increased its dividend for 41 consecutive years. Wal-Mart’s competitive advantage comes from its massive size. The company places significant pressure on suppliers to cut costs. Wal-Mart returns these savings to consumers, increasing size, and reducing prices further.
Wal-Mart’s most recent quarterly report showed lethargic but positive revenue growth in each of the company’s 3 divisions versus the same quarter a year ago.
- Wal-Mart US increased revenue 2%
- Wal-Mart International increased constant currency revenue 3.4%
- Sam’s Club increased revenue 0.5%, excluding fuel
Wal-Mart’s future growth potential comes from several sources. In the near term, the company can grow revenues by increasing same store sales. The company has experienced stocking problems which will add to revenue when fixed. The company’s long-term growth rests with its ability to gain share in international markets. Wal-Mart international posted the strongest revenue growth out of any division for the company last quarter (on a currency adjusted basis), but 3.4% is low compared to the growth experienced by other multinational corporations internationally.
Additionally, Wal-Mart can grow sales by continuing to build its e-commerce program. Wal-Mart’s e-commerce business grew revenues a remarkable 27% last quarter versus the same quarter a year ago. The company has plans to offer same day shipping by leveraging its extensive distribution network.
Source: Wal-Mart 1st Quarter Report
W.W Grainger Current Events
Grainger actually has the longest streak of consecutive dividend payments out of the 3 stocks explored in detail in this article. The company has paid increasing dividends for 43 consecutive years. Grainger is not as ubiquitous as PepsiCo or Wal-Mart. The company is the leading broad line supplier of maintenance, repair, and operating products in the US.
Grainger has huge growth potential. The company operates in the highly fragmented maintenance, repair, and operating sector. Grainger currently owns only 6% of the US market, while the next 9 largest competitors make up only 24% of the market. Grainger is rapidly stealing share from smaller operations. The company expects 3% to 4% sales growth from market share gains alone in 2014.
Soource: 2014 Grainger Factbook
Both PepsiCo and Wal-Mart are ranked highly based on the 8 Rules of Dividend Investing. The 8 Rules of Dividend Investing work similarly to the ranking system used in this article by ranking businesses with 25+ years of dividend payments without a reduction over several metrics that have historically outperformed the market. W.W. Grainger also ranks highly, within the Top 15.
Investing to systematically using a variety of metrics that have outperformed historically and make sense logically can give you more confidence in your investments by elucidating the investment rational. It is not the only way to invest, and each person should invest using the style that suites their temperament best. With that said, systematic investing can greatly reduce investor bias by making explicit the assumptions used in selecting stocks.