Earnings often dominate the investing headlines, but according to a growing body of research, a better indicator of future stock returns may be gross profitability.
The research focuses on gross profits because “a company’s earnings reflect myriad factors having nothing to do with how profitable it is likely to be in future years, says Robert Novy-Marx, a finance professor at the University of Rochester,” Mark Hulbert writes in a MarketWatch column. He says Novy-Marx divides gross profits by total assets in order to compare companies of different size. Research has found that historically, firms in the top 20% percent of the market on that basis have outperformed those in the bottom 20% by 3.5 percentage points annually over the next year.
Hulbert warns not to put all your eggs in one basket, however, noting that valuation is always important. In fact, Novy-Marx has found that the most-profitable companies with the cheapest valuations have outperformed the least-profitable companies with the highest valuations by an average of 7.4 percentage points a year.