January 10th, 2018 | by Gregg S. Fisher, CFA, "Invest with Reason"
The Curious Case of Low Profitability and High Stock Returns
It seems almost axiomatic that more-profitable businesses should generate better returns for investors than their less-profitable counterparts. In fact, the historic link between profitability and stock performance has been well documented by academic research.* Yet, in the recent market environment, this investment principle has been turned on its head. What is going on here?
Exhibit 1 illustrates this market aberration. Over the long term (50 years), the return premium for the most-profitable stocks compared to the least-profitable stocks was a wide 3-percentage points annualized, whereas since 2012 the pattern has reversed, with the most-profitable securities trailing the least-profitable ones by a point per year.
Some observations may help to explain this peculiar divergence from the historical norm. Investors in recent years have been unusually complacent about (or comfortable with taking on) risk, and so are allocating more capital to companies with low (or sometimes no) profitability. As with the “tech bubble” of the late 1990s, stock prices of certain businesses have increased dramatically when compared to underlying company fundamentals such as profitability. The rapid growth of market cap-based indexing in recent years has in effect exacerbated the trend by boosting allocations to expensive stocks in the portfolios of index investors.
The FAANG stocks (Facebook, Amazon, Apple, Netflix, Google) are an excellent case in point. These are dynamic and highly successful businesses, but of the five only Apple’s market cap is well-aligned with its profitability (see Exhibit 2). The others’ market values are much larger than their profits would suggest as compared with their sector peers. One byproduct of the market’s skew towards less-profitable companies is that there has been an unusual shift in (relative) profitability towards smaller-cap companies.
Just as with Growth vs. Value or Large vs. Small, we can’t predict when the cycle will turn (see After a Decade of Strong Large Cap Growth, is There a Place for Small Value in Your Portfolio?). Unusual market environments come and go, but we see no reason to believe that basic principles of investing—such as the relationship between risk and return or the centrality of company fundamentals—have been repealed. We invite you to read our extensive research on the recent profitability and market anomaly—and how, as investment managers, we are positioning equity portfolios—in this recent paper: “Does It Still Pay to be Profitable? Not as Much Recently…”