New Method For Stock Selection
During 2013, The Journal of Financial Economics is going to publish an article by Robert NovyMarx, a University of Rochester professor. The paper will show bargain-priced quality stocks outperformed the overall market by > four percentage points between 1963 and 2011. This gap is even greater than the gap between value and growth stocks over the same period. Moreover, this “quality bargain” approach tends to have less severe losses in market downturns and sometimes has a negative correlation to value.
The approach is fairly straightforward: Instead of focusing on a company’s net earnings, use total revenues minus basic expenses. The belief is that money used for capital improvements, research, or other things that might result in a big payoff later should be “captured” in this type of raw profitability.
A few fund companies are beginning to embrace this approach. Dimensional Fund Advisors (DFA) has introduced four funds that combine quality with pricier “growth” stocks. AQR Funds is expected to start three funds that blend quality, cheap “value,” and fastmoving “momentum” stocks.
For each potential stock, the company’s cost of goods sold is subtracted from its revenue; the resulting number is divided by the company’s total assets. In general, the ratio should be 0.33 or higher. Next, look to see if the same company has a low price-to-book-value ratio (something readily available). Ideally, the P/B ratio should be 1.7 or less. The initial universe (sample) to make these calculations should be big companies.