Warren Buffett is known as the world's most famous "value investor," but that term is not well understood.

In his latest letter to shareholders (.pdf), Buffett includes a great paragraph explaining that value is not synonymous for cheap.

More than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain-hunting, with results ranging from tolerable to terrible. Fortunately, my mistakes have usually occurred when I made smaller purchases. Our large acquisitions have generally worked out well and, in a few cases, more than well.

As Charlie Munger evidently taught Buffett, it's better to buy high-quality businesses for a fair amount than finding assets at bargain basement prices.

But what does this mean in practice?

Coincidentally, Jason Zweig has a great column in the WSJ today on some new academic work that attempts to define "quality" in a stock. The study shows that yes, quality stocks do tend to outperform.

Research to be published soon in the prestigious Journal of Financial Economics by Robert Novy-Marx, a finance professor at the University of Rochester, shows that bargain-priced "quality" stocks outperformed the overall market by more than four percentage points annually between 1963 and 2011. This stunning margin is even higher than that earned over the same period by traditionally measured cheap "value" stocks, but usually with less severe losses in market downturns. Quality also tends to do well when value does poorly — and vice versa.

Novy-Marx has already done a lot of published research in this area, which you can see here on his webpage.

In his most recent paper (.pdf) he explains how to define "quality" and the benefits of using such a filter:

Novy-Marx (2012) shows, however, that a simple quality metric, gross profits-to-assets, has roughly as much power predicting the relative performance of different stocks as tried-and-true value measures like book-to-price. Buying profitable firms and selling unprofitable firms, where profitability is measured by the difference between a firm's total revenues and the costs of the goods or services it sells, yields a significant gross profitability premium.

While analysts spend a lot of time thinking about bottom line earnings, and to a lesser extent free cash flow and earnings before interest and deductions (EBIT), empirically gross profitability, which appears almost at the top of the income statement, is a much better predictor of a firm’s future stock performance.

So what does this mean in practice?

It helps explain the amazing performance of a stock like Amazon, as Zweig goes on to note in his column today.

Over the past four quarters, for instance, Amazon.com AMZN generated $61.1 billion in revenues. Its cost of goods sold, or basic expenses, amounted to $44.3 billion, leaving gross profits of $16.8 billion on total assets of $32.6 billion. But, largely because the company spent nearly $14 billion on R&D and marketing, its reported net income was negative $39 million.

Amazon is one of the most controversial stocks in the world, because it's price-to-earnings ratio has always been sky high. It's currently trading at a nosebleed 180x forward earnings.

But it's one of the highest quality companies in the world, generating incredible gross profits relative to its assets, and the stock has had an amazing run because of it.

For more on Novy-Marx's research on quality investing, see his work here >