The following article appeared in the 1 April 2013 issue of the Systematic Value Investor newsletter.

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Do you think that the quality of a business makes any difference in terms of returns compared to only buying undervalued companies?

It doesn't, but we may have found a quality ratio that helps.

As you know, our experience testing quality ratios in our book Quantitative Value Investing In Europe: What Works for Achieving Alpha has been mixed.

It doesn't work

Return on invested capital and return on assets as single factors weren't good predictors of future returns.

Even though high-quality companies did do better than junk companies using both ratios, the results were not linear, and choosing only high-quality companies would not have helped you to outperform the market consistently.

A better quality ratio?

In a fascinating paper we stumbled on recently called The Quality Dimension of Value Investing (click on the name to go to the paper), Robert Novy-Marx defined a quality ratio that, according to his tests, does lead to better results.

How calculated

Robert defined a quality company as one with a high gross income ratio which is calculated by dividing gross profits by total assets. Whereas gross profit is calculated as sales minus cost of sales, and assets are total assets as shown in the company’s balance sheet.

In the paper, Robert shows that this simple ratio has about the same predictive power as other valuation ratios such as price to book, for example.

Does it work?

We of course wanted to test if it was a good single factor to use. And our year back test (on European companies) came up with the following result:

1: Quintiles

2: Compound annual growth rate

As you can see, the results are (apart from Q1 to Q2) nearly linear. And companies with a high-quality ratio did substantially better than companies with a low ratio.

The STOXX Europe 600 index over the same period had a compound annual growth rate of -0,82%, worse than even the worse quintile, most likely because of the banks being included in the index and because the index is market-weighted.

Better than ROA & ROIC

This is thus a much better quality factor you can use compared to either return on assets or return on invested capital

We are not convinced

Because of our unconvincing experience with other quality ratios, we are not yet completely convinced by the gross income ratio. We worry that it may be selective data mining (looking for a ratio that worked over a specific period but that may not work in the future) and would like to test it further.

In summary

This is what we think of quality ratios at the moment. High-quality companies may not make you rich, but you have a good chance of becoming poor if you buy low-quality companies. If it works, you will see it You can, however, be sure that if we find the gross income ratio valuable (after further testing), it will be included in the screener.