NEW YORK, June 11, 2014 /PRNewswire/ — Best-selling author and renowned financial advisor Dr. Phil DeMuth says, "The Profitability Premium – buying companies with high top-line profitability – is the most important finding to come of academe in the past decade."
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It traces back to Charlie Munger, Warren Buffett's co-chairman at Berkshire Hathaway. Back in the 1950s, Buffett was strictly a value stock picker, buying stocks that were cheap with a large margin of safety. Munger is credited with raising Buffett's sights to include high-quality companies selling reasonable prices. American Express and Coca-Cola were added to the Berkshire portfolio, with tremendous results.
Flash forward to 2012: Professor Roberty Novy-Marx at the University of Syracuse has come up with the academic evidence to prove Munger's intuition. Novy-Marx found that a company's gross profitability (technically defined as the ratio of its gross profits to its assets) was an excellent predictor of its future stock price. "These companies seem to have a significant moat or franchise that deliver high returns," said DeMuth. "Examples today might be companies like Apple, Starbucks, J&J or Visa."
Novy-Marx's work caught the attention of this year's Nobel-prize winning economist Gene Fama. Fama and co-researcher Kenneth French became famous for academically validating the outperformance of the "value" factor – buying stocks that are cheap – that has been the other piston driving Berkshire Hathaway's success under Buffett.
They found that combining the new "profitability" factor with the old "value" factor worked better than either of them taken alone, offering higher returns for less risk. The profitability screen made sure they were not buying cheap value stocks that were cheap because they were dogs, and the value screen ensured they were not overpaying for profitable companies that were too expensive.
Their findings have already been implemented by "quant" mutual fund companies like Dimensional Funds and AQR Capital. From there, they can be expected to go downmarket to retail funds available to ordinary investors.
Meanwhile, academic research into profitability is heating up. A team of researchers at the University of Chicago let by Professor Ray Ball has just proposed yet another way of measuring profitability.
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About Phil DeMuth
DeMuth's is author of The Affluent Investor, as well as having co-authored nine bestselling books with economist Ben Stein (including the Yes, You Can" series: Yes, You Can Get a Financial Life, Still Retire Comfortably, Supercharge Your Portfolio, Time the Market, and Become a Successful Income Investor) and two titles in "The Little Book" series: The Little Book of Alternative Investments and Bulletproof Investing). Both a psychologist and registered investment advisor, he's written for The Wall Street Journal, Barron's, the Journal of Financial Planning, Human Behavior, and Psychology Today. He's been quoted in The New York Times, Fortune, Yahoo! Finance, theStreet.com, On Wall Street, "Profiled for Success" in Research Magazine, and appeared in hundreds of outlets, including CNBC, Forbes on Fox, Fox & Friends, FBN, Bloomberg, WEALTHTRACK, and Wall Street Week with Fortune. He's Managing Director of Conservative Wealth Management LLC, a SEC-registered investment advisor to high-net-worth individuals and their families.
DeMuth's original Forbes.com latest article on the Profitability Premium can be found at: http://www.forbes.com/sites/phildemuth/
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