Ongoing research into the fundamental drivers of stock returns continues to identify opportunities for outperformance.

Robert Novy-Marx recently published an article in the Journal of Financial Economics, entitled “The Other Side of Value: The Gross Profitability Premium,” which has created a stir in both academia and the passive investing world. Novy-Marx’s primary finding was that more profitable companies – as measured by the ratio of gross profits to assets – generate significantly higher returns than less profitable companies despite having materially higher valuations.

Novy-Marx also found that passive investment strategies that target the premiums associated with value stocks can be enhanced by an exposure to stocks issued by more profitable companies. Expect these findings to be swiftly incorporated into products.

Dimensional Fund Advisors Canada ULC of Vancouver, whose U.S.-based parent has undertaken its own research on this phenomenon, is currently revising certain of its fund strategies to capitalize on this new dimension of stock returns.

This research represents just one facet of a trend toward better definition of the characteristics of quality stocks. New York-based MSCI Inc. recently launched the MSCI quality indices, designed to identify quality growth stocks based on three major fundamental variables: stability of annual earnings growth, low financial leverage and high return on equity.

The historical performance of the MSCI USA quality index (a.k.a. the MUXI) is attractive. From January 1982 through June 2013, this index had an annualized return of 13.1% – nicely outdistancing the 11.4% return of the S&P 500 composite index.

The MUXI also had better Sharpe and Sortino ratios than the S&P 500 did, indicative of superior returns relative to overall and downside volatility. The MUXI’s maximum drawdown, based on monthend returns, was minus 40.5% – much lower than the minus 51.0% of the S&P 500.

The style attribution analysis conducted by my firm, Tacita Capital Inc., found that although the MUXI performs primarily like large-cap growth stocks, at certain times its performance is more akin to large-cap value stocks.

This shift to value was pronounced from 2001 through 2006, when large-cap growth stocks suffered after the tech crash, allowing the MUXI to outperform traditional growth indices such as the Russell 1000 growth index.

Standard & Poor’s Financial Services LLC of New York has been ranking U.S. common stocks on the basis of their long-term growth and the stability of their earnings and dividends for more than 50 years. Stocks are rated from a low of C to a high of A+ in what are commonly referred to as “S&P quality rankings.”

The S&P 500 high-quality rankings index (SPHQRI) is comprised only of stocks rated from A- to A+, overweighted to the A+ and A stocks. From May 1997 to June 2013, the SPHQRI had an annualized return of 8.1% – outperforming the 6.3% return of the S&P 500 composite index. Although the SPHQRI modestly outperforms the S&P 500 on a risk-adjusted basis, the former index’s drawdown performance is less impressive. The SPHQRI’s maximum drawdown, based on monthend returns, was minus 53.3%.

Unlike the MUXI, the SPHQRI has, in part, a dividend focus and thus historically has included a healthy exposure to the financial services sector. Overall, the SPHQRI tends to be focused on value stocks, although recently its performance has been shifting toward large-cap growth stocks.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned herein.

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