Gross profitability — gross profits scaled by assets — predicts the cross-section of returns about as strongly as book-to-market. Profitable firms earn significantly higher returns than unprofitable firms, and because profitability and value are negatively correlated, combining them roughly doubles the Sharpe ratio of either alone. This is the founding paper of the modern quality / profitability factor (RMW in the Fama-French five-factor model).
What anomaly it documents
Predictor: gross profits-to-assets (GP/A) = (revenue − cost of goods sold) / total assets.
Direction: positive — more profitable firms earn higher average returns.
Key insight: gross profit is the "cleanest" accounting measure of true economic profitability. The further down the income statement you go (operating income, net income), the more the number is polluted by items unrelated to productive activity (R&D and advertising expensed today build future profits; interest, taxes, one-offs add noise). Gross profitability therefore predicts returns better than earnings-based profitability.
OSAP predictor: GP.
How to construct it
Sorting variable: (REVT − COGS) / AT — revenue minus cost of goods sold, divided by total assets.
Universe: US nonfinancial common stocks with required Compustat items.
Portfolio formation: annually (June), using the most recent fiscal-year financials with the standard accounting lag.
Long / short: long high gross-profitability, short low gross-profitability.
Weighting: value-weighted; NYSE breakpoints (the premium is not a microcap artifact — it survives value-weighting and is actually stronger in large caps than the value premium is).
Rebalancing: annual.
Evidence and replication
Period
Sharpe (approx)
Notes
Source
IS (1963–2010)
~0.4–0.5 standalone
comparable to value
this paper
IS value + profitability combo
markedly higher
the headline result
this paper
OOS (post-2013)
positive, holds reasonably
—
post-publication
OSAP replication (GP)
clear, positive
—
Chen & Zimmermann 2022
Gross profitability delivers a premium of similar magnitude to value, with the crucial property that the two are negatively correlated — profitable firms tend to be growth (low B/M), value firms tend to be unprofitable — so a combined long profitable-value / short unprofitable-growth book hedges each leg and lifts the Sharpe substantially.
Profitability has held up better out of sample than many anomalies and directly motivated Fama & French (2015) adding profitability (RMW) and investment (CMA) to their model.
Why it might work
Risk-based (Novy-Marx's framing): profitable firms are, perhaps counterintuitively, riskier in a way the market compensates — they have more of their value in risky, longer-duration growth options / future cash flows. Profitability is the "other side" of the same value coin.
Mispricing: markets may underappreciate the persistence of profitability, underpricing quality firms — the quality-at-a-reasonable-price logic.
Quality umbrella: gross profitability is the empirical anchor of the broader "quality" factor (Asness, Frazzini & Pedersen, "Quality Minus Junk"), which bundles profitability, growth, safety, and payout.
Limitations and risks
Definition sensitivity: results depend on using gross profits rather than earnings; operating- and net-income versions are weaker.
Crowding: profitability/quality is now a mainstream factor harvested by many funds.
Correlation regimes: the value+profitability diversification benefit relies on their negative correlation, which can compress in some regimes.
No free full text: paywalled; see DOI (a working-paper version is often available from the author's site).
Key references
Novy-Marx, R. (2013) — The Other Side of Value: The Gross Profitability Premium — Journal of Financial Economics — DOI: 10.1016/j.jfineco.2013.01.003
Fama, E. & French, K. (2015) — A Five-Factor Asset Pricing Model — Journal of Financial Economics
Asness, C., Frazzini, A. & Pedersen, L. (2019) — Quality Minus Junk — Review of Accounting Studies
Ball, R., Gerakos, J., Linnainmaa, J. & Nikolaev, V. (2016) — Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns — Journal of Financial Economics
Chen, A. & Zimmermann, T. (2022) — Open Source Cross-Sectional Asset Pricing — Critical Finance Review
