Some think pain today will lead to gains tomorrow, but analysis of U.S.-listed companies points to risks
In a perfect investing world, a firm’s share price would reflect the risks it carries, including massive debt, an unsustainable business model, and lack of profitability. But in the real world, where fear and greed can generate gale-like tailwinds, even companies with weak revenue can enjoy multibillion-dollar IPOs and become mainstays of the stock market.
“[O]f listings on the New York Stock Exchange and Nasdaq with at least one year of the relevant earnings data, more than 35% were unprofitable in their cumulative results for the four quarters ended Sept. 30, 2019,” Derek Horstmeyer, an associate professor of Finance at George Mason University’s Business School, noted in a piece for the Wall Street Journal.
Horstmeyer noted Uber, Pinterest, Peloton, Lyft, and Snap as examples of such companies, which certain investors apparently get shares of in hopes that they’d become the next Amazon.com. But based on an analysis of U.S.-listed companies, he maintained that unprofitable firms “exhibit greater risk than profitable companies across the board.”
Starting with the total universe of companies listed on the NYSE and Nasdaq with earnings disclosures for the past five years, he determined their cumulative net income over the prior four quarters in a given year: the ones with positive net income were branded “profitable,” while those with negative net income were “unprofitable.”
“To avoid any look-ahead bias in the data, measures of profitability were based on the year preceding the start date of any one-year stock returns calculated,” Horstmeyer said.
In what should be a blinding flash of the obvious, he found that shares of unprofitable companies have lagged those of their profitable counterparts over the past five years. Median annualized share return for the profitable cohort was 16%, compared to 4.2% for the unprofitable group. Unprofitable companies also exhibited more volatility, with a standard deviation in returns of 59.3% compared to 29.2% for profitable firms during the period.
He also examined interest-rate risk within equities, as measured by how rate hikes from the Federal Reserve impacted returns. While rate increases tend to exert an immediate drag on earnings for stocks in general, Horstmeyer found 50% greater interest-rate risk among unprofitable companies compared to profitable ones.
“To be precise, for the 30 days following each of the nine rate increases in the past five years, the returns of unprofitable companies fell an average of 2.2%, compared with 0.8% for profitable companies,” he said.
