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NBER WORKING PAPER SERIESTHE OTHER SIDE OF VALUE:GOOD GROWTH AND THE GROSS PROFITABILITY PREMIUMRobert Novy-MarxWorking Paper 15940http://www.nber.org/papers/w15940NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts AvenueCambridge, MA 02138April 2010
Financial support from the Center for the Research in Securities Prices at the University of Chicago
Booth School of Business is gratefully acknowledged. The views expressed herein are those of the
author and do not necessarily reflect the views of the National Bureau of Economic Research.
NBER working papers are circulated for discussion and comment purposes. They have not been peer-
reviewed or been subject to the review by the NBER Board of Directors that accompanies official
NBER publications.
© 2010 by Robert Novy-Marx. All rights reserved. Short sections of text, not to exceed two paragraphs,
may be quoted without explicit permission provided that full credit, including © notice, is given to
the source.
The Other Side of Value: Good Growth and the Gross Profitability PremiumRobert Novy-MarxNBER Working Paper No. 15940April 2010JEL No. G12
Profitability, as measured by gross profits-to-assets, has roughly the same power as book-to-marketpredicting the cross-section of average returns. Profitable firms generate significantly higher average
returns than unprofitable firms, despite having, on average, lower book-to-markets and higher market
capitalizations. Controlling for profitability also dramatically increases the performance of value strategies,
especially among the largest, most liquid stocks. These results are difficult to reconcile with popular
explanations of the value premium, as profitable firms are less prone to distress, have longer cashflow
durations, and have lower levels of operating leverage, than unprofitable firms. Controlling for gross
profitability explains most earnings related anomalies, as well as a wide range of seemingly unrelated
profitable trading strategies.Robert Novy-MarxBooth School of BusinessUniversity of Chicago5807 South Woodlawn AvenueChicago, IL 60637and NBERrnm@chicagobooth.edu
1 Introduction
Profitability has roughly the same power as book-to-market predicting the cross-sectionof average returns. It is also complimentary to book-to-market, contributing economicallysignificant information above that contained in valuations. These conclusions differ dra-matically from those of other studies (Fama and French (1993, 2006)), which find thatprofitability adds little or nothing to the prediction of returns provided by size and book-to-market. The difference is that “profitability” here is measured using gross profits, notearnings. Gross profitability represents “the other side of value.” Strategies based on grossprofitabilitygenerate value-likeaverage excess returns, despite being growth strategies thatprovidean excellent hedgefor value. Because thetwo effectsareclosely related,it isusefulto analyze profitability in the context of value.Value strategies hold firms with inexpensive assets and short firms with expensive as-sets. When a firm’s market value is low relative to its book value, then a stock purchaseracquires a relatively large quantity of book assets for each dollar spent on the firm. Whena firm’s market price is high relative to its book value the opposite is true. Value strate-gies were first advocated by Graham and Dodd in 1934, and their profitability has beendocumented countless times since.Berk (1995) argues that the profitability of value strategies is mechanical. Firms forwhich investors require high rates of return (i.e., risky firms) are priced lower, and conse-quently have higher book-to-markets, than firms for which investors require lower returns.Because valuation ratios help identify variation in expected returns, with higher book-to-markets indicating higher required rates, value firms generate higher average returns thangrowth firms.A similar argument suggests that firms with productive assets should yield higher av-erage returns than firms with unproductive assets. Productive firms for which investorsdemand high average returns to hold should be priced similarly to less productive firmsfor which investors demand lower returns. Variation in productivity therefore helps iden-1

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