Thursday, June 5, 2014

An easy way to pick a winning stock

Sometimes investors overlook the most obvious answers.

That certainly appears to be the case when searching for companies that will be the most profitable in the future.

It turns out that we need look no further than the firms that are most profitable today, defined in terms of gross profits, or total sales less cost of goods sold. That at least is the discovery of a fast-rising body of research.

To be sure, that research doesn’t suggest that all of the currently most profitable stocks will be at the top of the list in future years. After all, past performance is no guarantee of future success. But, on average, they should be far more profitable than firms currently making the least. And their stocks will have performed better, too.

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The implication: Between two companies that are otherwise similar, pick the one with the greatest profitability.

Note carefully that this new research focuses on gross profits rather than earnings. That is 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.

For comparability between companies of different sizes, Prof. Novy-Marx divides gross profits by total assets. Take Apple (AAPL)  , whose total sales in fiscal 2012 were $156 billion, versus $88 billion in cost of goods, for a gross profit of $68 billion. When divided by its total assets of $176 billion, the company’s gross profitability percentage is 39%.

Apple’s profitability is in the middle of the pack among nonfinancial companies in the S&P 500 (SPX)  . The most profitable, according to AQR Capital Management, a money-management firm in Greenwich, Conn. with more than $80 billion in assets, is staffing firm Robert Half International (RHI)  , whose gross profitability is 119%. In second place is cosmetics giant Estée Lauder (EL)  , at 114%.

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Assuming these companies are typical of the 20% of firms with the highest profitability ratios, the stocks of Robert Half and Estée Lauder should do 3.5 pecentage points better over the next year than the 20% of stocks at the bottom.

Furthermore, according to Gerard O’Reilly, head of research at Dimensional Fund Advisors in Austin, Texas, which manages more than $300 billion, even though the most-profitable companies have delivered higher performance than the least-profitable companies with similar valuations, they have not been more volatile.

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It is a rare, and winning, combination to get greater returns without greater risk, of course.