Novy-Marx (2013): The Gross Profitability Premium Explained

#The Paper at a Glance

Title: The other side of value: The gross profitability premium

Authors: Robert Novy-Marx (University of Rochester)

Published: Journal of Financial Economics, 2013

DOI: 10.1016/j.jfineco.2013.01.003

Before this paper, "profitability" wasn't considered a distinct factor. Novy-Marx showed that the simplest profitability measure imaginable—gross profit divided by assets—is just as powerful as the value factor for predicting returns.

#What the Paper Found

The Surprising Power of Simplicity

Novy-Marx tested many profitability measures: net income, operating income, EBITDA, free cash flow. But the simplest measure won:

Gross Profitability = (Revenue - Cost of Goods Sold) / Total Assets

This measures a company's fundamental pricing power before any operating decisions, financing choices, or tax strategies muddy the picture.

"The Other Side of Value"

Here's the key insight: profitable firms tend to look expensive on traditional value metrics. A company with high margins and strong pricing power will trade at a premium price-to-book ratio.

This means the value factor (buy cheap stocks) and the profitability factor (buy profitable stocks) are negatively correlated. Cheap stocks tend to be unprofitable. Profitable stocks tend to look expensive.

This negative correlation is a feature, not a bug. It means combining value and profitability gives you diversification—when one factor struggles, the other often helps.

#Why Gross Profitability Works

1. It Captures Competitive Advantage

Gross profitability reflects a company's ability to charge more than its direct costs. Companies with high gross margins have: - Strong brands - Proprietary technology - Network effects - Pricing power

These advantages tend to persist, generating sustained above-market returns.

2. It's Hard to Manipulate

Unlike net income (which can be managed through depreciation, one-time items, and tax strategies), gross profit is relatively clean. Revenue minus COGS leaves little room for accounting games.

3. It Predicts Future Earnings

Companies with high gross profitability today tend to maintain high profitability in the future. This earnings persistence is exactly what drives sustained stock returns.

#The Value-Quality Combination

Novy-Marx's most practical insight was that value + quality beats either alone:

The combined strategy nearly doubles the Sharpe ratio because the two factors move independently. When value stocks lag (as they did 2017-2020), profitable stocks often hold up.

#Impact on the Field

Novy-Marx's paper triggered a wave of research:

• Fama & French (2015) added a profitability factor (RMW) to create their five-factor model
• Asness et al. (2019) expanded "quality" into profitability, growth, safety, and payout
• Ball et al. (2016) refined profitability measurement using cash-based metrics

The modern consensus: profitability belongs alongside value, momentum, and size as a core factor.

#How This Applies to Our Rankings

Our profitability factor builds on Novy-Marx's foundation. We use the more advanced cash-based measure from Ball et al. (2016), but the core insight is the same: profitable companies systematically outperform unprofitable ones.

We weight profitability at 30%—the highest weight in our model—reflecting the academic consensus that quality/profitability is the most robust and consistent factor.

Combined with our value factor (15% weight), we capture exactly the diversification benefit Novy-Marx identified.

See highest-profitability stocks →

#Academic Source

Novy-Marx, R. (2013). "The other side of value: The gross profitability premium." Journal of Financial Economics, 108(1), 1-28.