Is gross profit superior to sales as a measure of firm footprint?

Summary

Sales is currently a factor in our Core footprint-weighted portfolio methodology. In this note, we compare Sales against Gross Profit, and discuss the rationale and historical back-test performance of each strategy. We argue Sales potentially provides a biased picture of a firm’s footprint as it fails to take into account firm or industry level differences in profit margins. 

Furthermore, Sales is also prone to double-counting and downstream bias. In contrast, Gross Profit measures a firm’s overall product ‘value-add’ (incorporates profit margins), and does not inherit biases prone in Sales weighting.

Hypothetically, replacing Sales with Gross Profit would reduce active risk by circa 1%, and roughly double the information ratio (IR) for developed markets in the longrun, maintains the value characteristics whilst reducing some sector and region biases.

Motivation

Gross Profit is Sales after accounting for the cost of goods sold (COGS) (variable costs), and in essence penalizes firms with lower margins as they add less value-add beyond their original inputs.

Weighting firms by Sales correctly identifies the size of a firm’s total output (or turnover), but overlooks the size of a firm’s inputs. This makes Sales weight not comparable between industries. Certain industries have lower margins but higher turnover that effectively generates significant headline sales. These firms would have their fundamental footprint unfairly enlarged. On the other hand, high margin, low volume industries would be unfairly shrunk.

Gross Profit favours stocks with high sales and high margins. Gross Profit blends a notion of profitability into Sales. Firms with higher Gross Profit produce goods or services with greater economic value-add. They are able to command a higher margin because of either favourable bargaining power over suppliers/customers and/or strategic positioning that reduces competitive rivalry, the threat of new entrants and product/service substitutes.

In contrast, firms with low profit margins provide limited economic value-add, and generally operate in sectors that either have low barriers to entry or have high competition. Using Sales would overstate the value of such firms’ economic footprint.