Quality Investing: Combining the Gross Profitability with the Free Cash Flow Yield

• Název práce v češtině: Quality Investing: ; Combining the Gross Profitability with the Free Cash Flow Yield
• Název v anglickém jazyce: Quality Investing: ; Combining the Gross Profitability with the Free Cash Flow Yield
• Klíčová slova: investování do kvalitních firem, hodnotové investování, hrubá profitabilita, volné peněžní toky
• Klíčová slova anglicky: Quality investing, value investing, gross profitability, free cash flow yield
• Akademický rok vypsání: 2014/2015
• Typ práce: diplomová práce
• Jazyk práce: angličtina
• Ústav: Institut ekonomických studií (23-IES)
• Vedoucí / školitel: Mgr. Iuliia Brushko, M.A., Ph.D.
• Řešitel: skrytý - zadáno vedoucím/školitelem
• Datum přihlášení: 18.06.2015
• Datum zadání: 18.06.2015
• Datum a čas obhajoby: 22.06.2016 09:30
• Místo konání obhajoby: IES
• Datum odevzdání elektronické podoby: 12.05.2016
• Datum proběhlé obhajoby: 22.06.2016
• Oponenti: PhDr. Jan Soudek

Předběžná náplň práce

Motivation:
The performance of every investor is usually compared to a selected benchmark. For a stock investor, a stock market index is commonly the most appropriate benchmark. According to the strong form of the efficient market hypothesis even the insider’s information is of no value. However, there were investors who had consistently better performance than the selected benchmark. These were mostly investors following principles of a value investing set by Graham and Dodd (1934). The basic definition of the value investing is buying undervalued firms. Firms with high book-to-market ratio are usually used for empirical testing. Many studies proved that portfolios made of firms with high book-to-market ratios outperform firms with low book-to-market ratios and also selected benchmarks (e.g. Fama and French 1992; Lakonishok, Shleifer and Vishny 1994).

Different quality measures were incorporated into value strategies with positive results (e.g. Sloan 1996; Greenblatt 2006; Piotroski and So 2012; Novy-Marx 2013). Novy-Marx (2014) compared the performance of the mostly known quality strategies and concluded that the strategy based on the gross profitability introduced by Novy-Marx (2013) performs the best among all tested quality strategies. Moreover, when the gross profitability was combined with high book-to-market ratio, results were even better than the original value investing strategy with only high book-to-market ratio firms.

Connecting this strategy to a modern valuation method may yield interesting results. The most common method for valuing firms is the discounted cash flow (DCF) method. This method uses the free cash flow predictions and discounts them back to the present time. However, strict value investors usually do not want to pay much or even pay at all for the future growth. This is why the current free cash flow generation should be the most important for a value investor. Hackel, Livnat and Rai (2000) showed that a portfolio consisting of firms that are strong free cash flow generators, have low financial leverage and trade at low price-to-free cash flow multiples outperforms the market. Jokipii and Vähämma (2006) showed that the same result holds also for Finnish companies. The free cash flow yield, defined as the free cash flow divided by the enterprise value, captures the effect of the current free cash flow generation together with low financial leverage and low price-to-free cash flow multiple. Adding the free cash flow yield to the gross profitability used by Novy-Marx (2013) is expected to contribute to the existing knowledge in the field of the quality investing.

Hypotheses:
1. Hypothesis #1: The free cash flow yield together with the gross profitability gives better results than gross profitability alone.
2. Hypothesis #2: Combining the free cash flow yield with the gross profitability and the book-to-market ratio gives better results than the book-to-market ratio alone.
3. Hypothesis #3: The long/short strategy performs better than the long-only strategy.

Methodology:
The first step will be the collection of the data needed to perform this study for which I will use a FactSet database. I will study only NYSE and NASDAQ listed companies for the longest period possible. The period will be dependent on the amount of historical data provided by the FactSet database. In case of some missing data, I will try to use also other reliable sources such as Bloomberg Terminal to complement the FactSet database.

The analysis will be conducted in a similar way as the analysis done by Novy-Marx (2014). Stocks will be ranked according to each strategy using chosen metrics which are the book-to-price ratio, the gross profitability and the free cash flow yield. After the ranking is done, two portfolios will be formed. Long/short portfolio that holds stocks in the top 30% according to the rank and short stocks located in the bottom 30% and long-only portfolio that holds only stocks ranked in the top 30% according to the ranking. Performance will be tested by Fama and French (1993) three-factor model.

I will also test the performance using subsamples and try find out, whether previous results hold also within these subsamples. I will test these hypotheses using only small cap companies, then mid cap companies and then large cap companies. I will also test these hypotheses in different time periods.

Expected Contribution:
I will broaden the current research in the area of quality investing. Novy-Marx (2014) showed that a strategy combining gross profitability which is a quality variable with the traditional value strategy based on high book-to-price ratio stocks performs better than the value strategy alone. I will try to improve the performance even further by adding another quality variable called free cash flow yield.

Outline:
1. Introduction
2. Literature review and motivation
3. Data and methodology
4. Results
5. Comparing results with other studies
6. Conclusion

Core Bibliography:
Fama, E.F., French, K.R., 1992. The cross-section of expected stock returns. Journal of
Finance 47, 427-465.

Fama, E.F., French, K.R., 1993. Common risk factors in the returns on stocks and bonds.
Journal of Financial Economics 33, 3-56.

Hackel, K.S., Livnat, J., Rai, A., 2000. A Free Cash Flow Investment Anomaly. Journal of Accounting, Auditing & Finance 15 (1), 1-24.

Novy-Marx, R., 2013. The Other Side of Value: The Gross Profitability Premium. Journal of Financial Economics 108 (1), 1-28.

Novy-Marx, R., 2014. Quality Investing. Working Paper.