Marx, “The Other Side of Value: The Gross Profitability Premium,” not only provided investors with new insights into the cross-section of stock returns but also led to the development of new factor models that incorporate a profitability factor.
Novy Marx's Findings
Before unpacking a more recent paper with new insights into how accruals and cash flows can impact profitability, I think it’s important to summarize some of Novy Marx's more fundamental findings on this premium:
• Profitability, as measured by gross profits-to-assets, has roughly the same power as the book-to-market ratio (a value measure) in predicting the cross-section of average returns.
• Surprisingly, profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios (for instance, higher price-to-book ratios).
• Profitable firms tend to be growth firms—they expand comparatively quickly. Gross profitability is a powerful predictor of future growth as well as earnings, free cash flow, and payouts.
