Profitability has mattered more lately than in prior phases of the market rally. This trend is also likely to continue into 2022, as the cycle matures, variants impede a full recovery, and policy decisions start to create more volatility – both macro and fundamental.
In this charting the market, I will showcase profitability trends and how a focus on quality stocks may help you to navigate the path ahead.
Profiting from No Profit?
As mentioned in our 2022 ETF Market Outlook, profitability was less of a concern during the first part of the pandemic rally. From May 2020 to May 2021, US stocks with negative earnings over the prior 12 months outperformed firms with positive earnings by 34%. Since May 2021, that performance trend has flipped. Unprofitable firms have trailed profitable ones by 7%.1
A more in-depth study reveals the same trends, but on a broader scale. The chart below shows the same analysis, but broken out by market cap, style, and region of focus. The trend was quite consistent throughout and shows that, at first, it didn’t matter if firms were profitable — until all of it sudden, it did.
Performance Difference between Non-Profitable and Profitable Stocks
Using a pure factor approach shows a similar trend. The chart below uses the Bloomberg US Pure Profitability Factor, a basket of stocks aimed at maximizing exposure to the profitability factor by going long stocks with high return-on-assets and return-on-equity levels, while shorting those that have poor figures for those metrics and optimizing to control for other factor or industry risks. As shown below, this highly concentrated quantitative exposure began to rally during the summer and has noticeably taken off since. Yet, it does remain below pre-pandemic levels, indicating the potential for more room to run.
Bloomberg US Pure Profitability Portfolio Total Return Index
The rationale for the turn in performance can be partly explained by three variables:
Rates began to rise, and given that some of these unprofitable firms have lofty growth expectations, a higher discount rate weighed on valuations
Liquidity-fueled exuberance waned after the initial bump, and fundamentals were once again in focus
The price reaction ran ahead of fundamentals, as earnings sentiment has soured over the past few months – in particular starting in June/July, as shown below
2022 EPS Revision: 3-Month Up-to-Downgrade Ratio
Intra-Sector Profitability Important
Despite the consistency of this performance in profitability, one could argue that there might be sector effects impacting these profitability trends. The data doesn’t support this notion. For starters, the Bloomberg Pure Profitability Factor seeks to neutralize sector effects and that exposure has rallied. However, if running the same analysis as earlier with styles and market caps but controlling for sector tilts by creating sector- only profitable and non-profitable portfolios indicates that, even within sectors themselves, a higher emphasis on profitability has been placed as of late than in earlier stages of the rally.
As shown below, only two sectors, Materials and Energy, have had non-profitable stocks beat profitable ones in the past few months within their respective sector. This differs from the earlier part of the rally when the magnitude of outperformance of non-profitable to profitable stocks was significant and consistent across all sectors.
Performance Difference between Non-Profitable and Profitable Stocks
Interestingly, one of the sectors (Energy) that has bucked the profit versus non-profit trend is also the one that scores the worst on a rank of profitably metrics overall, as defined by the process to create the Bloomberg Pure Profitability Factor (Return-on-assets, Return-on-equity, Return-on-capital, and EBITDA Margin). Within the S&P 500, Energy has zero firms in the top decile of highly profitable firms. This tells me that within that specific sector, there really isn’t a big difference between profitable and non-profitable firms. Therefore, the intra-sector analysis for that sector is not that meaningful.
On the flip side, within the S&P 500, Health Care and Tech have the most names within the top decile of these combined profitability rankings, at eight and 18, respectively. They also have most on a net-basis, after considering the number of firms from those sectors in the bottom decile of quality —a slight indication that those two sectors may be of higher quality than others.
Focus on Profits for the Path Ahead
The outlook for risk assets remains constructive given supportive, albeit slowing, growth and still easy monetary policies, even as tightening begins. Yet, with growth transitioning to a simmer from a boil, there has been a greater emphasis on firms with higher quality balance sheets and reliable profitability.
I’d expect this to continue into 2022, and investors may want to consider adding a quality overlay to portfolios —either by focusing on quality with factor exposures or by overweighting market sectors like Tech and Health Care.
1 Per Bloomberg Finance, L.P. data as of December 7, 2021. Based on a non-rebalanced equal weighted composite of stocks in the Russell 3000 Index that had trailing negative 12-month earnings-per-share compared to a non-rebalanced equal weighted composite of stocks in the Russell 3000 Index that had trailing positive 12-month earnings-per-share. Stocks with an initial public offering (IPO) during the time frame were not considered, as the security needed to have a full period return to be included.
The EBITDA margin is a measure of a company's operating profit as a percentage of its revenue. The acronym EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Knowing the EBITDA margin allows for a comparison of one company's real performance to others in its industry.
MSCI ACWI Ex-US Index
Captures large, mid and small cap representation across 23 Developed Markets (DM) and 23 Emerging Markets (EM) countries excluding the US.
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The MSCI Em (Emerging Markets) Index is a free-float weighted equity index that captures large and mid cap representation across Emerging Markets (EM) countries. The index covers approximately 85% of the free float- adjusted market capitalization in each country.
Return on Assets
Return on assets (ROA) is an indicator of how well a company utilizes its assets in terms of profitability.
Return on Capital
Return on capital, or return on invested capital, is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders.
Return on Equity
The return on equity is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on assets minus liabilities.
Russell 3000 Growth and Value Index
A market capitalization weighted index. All the stocks in the underlying parent index are allocated into value or growth. Stocks that do not have pure value or pure growth characteristics have their market caps distributed between the value & growth indices.
Russell 3000 Index
A market capitalization weighted index of US stocks.
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