Wednesday, May 12, 2010

"Gross Profitability as a Stock Return Predictor" (and a look at John Mauldin's track record)

CXO does a good job testing various approaches to investing. They also look at the predictive prowess of individual gurus.*
(Which is one of the reasons you don't see us quoting a lot of the more colorful pundits)

I'll lead with the conclusion:
...In summary, evidence indicates that investors may be able to exploit gross profits-to-assets as a predictor of individual stock returns, especially within industry. The effect is comparable in magnitude and complimentary to book-to-market, such that combining them is especially powerful.
Here's the intro:

Is level of profitability alone, and in combination with other firm/stock characteristics, a useful indicator of future stock returns? In his April 2010 paper entitled “The Other Side of Value: Good Growth and the Gross Profitability Premium”, Robert Novy-Marx investigates the power of the gross profits-to-assets ratio to predict returns for individual stocks as a standalone indicator and in combination with the book-to-market ratio. Using annual firm characteristics and stock price data for a broad sample of U.S. companies spanning 1962-2009, he concludes that:

  • Gross profits-to-assets outperforms both earnings and free cash flow in predicting future returns of individual stocks. In fact, it completely subsumes the predictive power of earnings. Gross profits-to-assets also predicts long run growth in earnings and free cash flow.
  • A value-weighted portfolio that is long (short) the fifth of stocks with the highest (lowest) gross profits-to-assets generates an average monthly excess return, relative to the risk-free rate, of 0.33% over the entire sample period. The associated three-factor alpha (adjusting for market, size and book-to-market) is 0.55% per month....MORE
Got that? Profits gooood!
[alright Mr. wiseacre: Tonto, Tarzan or Frankenstein? -ed]

*For example, here's their analysis of the much quoted John Mauldin:
John Mauldin’s Thoughts (last updated May 8, 2010)

As suggested by a reader, we evaluate here the weekly commentary of John Mauldin “Thoughts from the Frontline” via since January 2001 (the earliest available). John Mauldin is president of Millennium Wave Investments and author of the book Bulls-Eye Investing, which “explain[s] to investors why we are in a secular bear market, and then show[s] them how to find absolute returns in a variety of funds and investments, including, but not limited to hedge funds.” He claims 1,500,000 newsletter readers. The table below extracts highlights from his commentary and shows the performance of the S&P 500 index over the 5, 21, 63 and 254 trading days after the publication date for each item. Red plus (minus) signs to the right of specific items indicate those that the market has subsequently proven right (wrong). We conclude that:
  • John Mauldin has been mostly negative about the U.S. economy and U.S. equities since early 2001. He maintains that stocks are in the early part of a secular bear market, with lower lows to come with future recessions over the next decade.
  • He addresses many economic issues and quotes others liberally in his long commentaries (so long that we sometimes resorted to key word searches to find mentions of stocks). He comments frequently on bonds, housing, gold and other markets.
  • One of his multi-step forecasts proved to be about equally right and wrong, so we evaluate it “0″ and grade it both right and wrong.
  • Based on subsequent stock market performance and our judgments about the accuracy of John Mauldin’s forecasts, his bottom-line advice about market direction was correct 41% of the time, below average. His forecast sample size is fairly large, as is our confidence in this conclusion.
  • It is relatively difficult to assess the accuracy of Mr. Mauldin’s market projections because of equivocation and because he often uses distant forecast horizons (which reduce effective sample size). Even while offering some short-term and intermediate-term forecasts, he occasionally denies the feasibility of forecasting stock market behavior over periods as short as a year.

In summary, John Mauldin’s accuracy in forecasting stock market behavior is below average. Confidence in this conclusion is fairly high...MORE