There was a time when rally narratives drove short-term performance. Back when stimulus programs fueled the recovery from the pandemic, investors focused on the “next new big thing” rather than whether a firm generated positive free cash flow. As a result, unprofitable stocks had outsized returns, outperforming profitable firms by 43 percentage points in the year following the markets bottom.1
All that has changed in the past few months, as sentiment has become uneven and monetary policy has begun to change the math around the narrative darlings. Rising rates have increased the discount rate that many of these high growth firms potential future cash flows were being discounted at. And that’s led to lower prices.
Higher real rates have normalized the opportunity cost as well. When real rates were negative, investing in a stock that generated no cash flow but had projections of robust future growth was more appealing than owning cash. Both investments burned money in the short term, but the latter offered upside potential. Today’s positive real rates change that opportunity cost. Now, only the unprofitable stock burns cash in the short term.
The performance trends of profitable and unprofitable stocks underscore how the market now trades more on fundamentals than narratives. In this Charting the Market, I will explore what this means for portfolios.
Profitable and Unprofitable Stocks Diverge
As the broader equity market has fallen, performance between firms that make money versus those that do not has diverged.
This analysis is based on equal-weighted portfolios formed from constituents within the Russell 3000 Index, partitioned by their trailing 12-month earnings-per-share (EPS). Profitable stocks are firms with positive EPS; unprofitable firms have negative EPS. Using an equal-weighted construct for this analysis removes any size bias of large versus small as the latter typically has more unprofitable firms (17% versus 46%, respectively).2
The chart below shows the performance over the past year of these two profit-based groupings. Profitable stocks have outpaced their unprofitable peers since June 2021. The turn in trend during late spring is an interesting inflection point.
Real rates bottomed out in mid-July and have increased ever since.3 Nominal rates did the same, doubling since then (3.0% versus 1.5% in July 2021) with large increases in 2022.4 Given those rate moves, the biggest differences in performance have occurred this year.
Profitable Versus Unprofitable Stock Monthly Performance
With strong performance every month, profitable stocks have outperformed unprofitable ones by 23% this year. In fact, profitable firms also have outpaced the broader market (-12.7%) as well as the average stock return (-15.4%) this year.
Profitable Versus Unprofitable Stock Year-to-Date Performance
But a straight-line average can be limiting. Separating profitability by quintiles can be more informative. The chart below shows that when broken out by quintiles of profitability, the most profitable stocks have had the strongest performance. The returns also worsen monotonically when moving down the quintile spectrum — underscoring the strength of this trend.
Average Return by Profitability Quintile
Strength of Profitable Stocks Extends Across Sectors
Some sectors are more profitable than others as a result of underlying operations, prevailing market trends, and macro variables. For instance, Financials now has the highest percentage of profitable firms (87%) while Health Care has the lowest (27%).5 Controlling for sectors can help answer whether the trend toward more profitable firms is consistent across sectors and not a result of any sector bias.
The chart below shows the difference between profitable stocks and unprofitable stocks within each sector. Across all sectors, there has been a consistent trend of cash flow positive stocks outperforming those that lose money. In fact, out of the 99 observable periods since the end of June 2021, only 22 (18%) had unprofitable stocks beat profitable ones within a specific sector.
Net Performance Spread by Sector of Profitable versus Non-Profitable Firms
The average return difference across sectors over the past year is also positive for every sector, as shown below. The measure of profitability was most important within Consumer Staples, Health Care, and Materials sectors, while there was not as much of a difference in the Energy sector. During this timeframe, the energy sector was up 74% and has been driven mainly by macro variables such as surging oil prices, not firm-specific variables.6
Average Net Performance Spread by Sector of Profitable Versus Non-Profitable Firms
Analyzing trends at the more granular industry level shows the fundamentals trend to be more robust. For instance, in five of the six industries within Consumer Staples, profitable firms have outpaced unprofitable ones in 2022 by an average 26%.7
Of the 68 Global Industry Classification Standard (GICS) level three industry groupings, 90% of firms have witnessed the profitable outpace unprofitable year to date.8 The average differential for industries with outperforming profitable stocks is 22.6%, compared to the differential when profitable firms underperform of -3.9%.9 This indicates a significant skew toward profitable as the distribution is far from normal.
The last piece of this sectoral analysis is a focus on innovative firms favored in the early pandemic rally. Non-profitable high-tech growth/innovative stocks are down 33% on average this year.10 Meanwhile, profitable high tech/innovative is down 11%, better than the broader market’s return.11 This shows both that not all stocks focused on innovative technologies are under pressure and that unprofitable innovative companies face a headwind.
Value Stocks Outperform
Given that most profitable firms have outperformed across market segments, it is fair to say that sector and industry biases have not been key factors within this trend. Valuations, however, have been.
Replicating the double sort approach popularized by Eugene Fama and Kenneth French, profitable and non-profitable stocks were partitioned into terciles and then sorted based on the start-of-year price-to-book ratio of the stocks in order to provide a valuation screen on top of the profitability screen.
Six portfolios were formed based on high-to-neutral-to-low profitability and high-to-neutral-to-low valuations. As shown below, while all positively profitable terciles had stronger performance than the low-or-negative profitability stocks, the inexpensive profitable bucket had the strongest relative performance of any of the six portfolios. The takeaway here is that high-quality (as measured by profitability) value stocks have done extremely well in this environment.
Year-to-date Returns for Double Sorted Portfolios
Emphasize High-Quality Value
Will high-quality value stocks continue to outpace low-quality expensive firms and the market itself? I see four tailwinds for profitable value stocks:
Higher rates: The Federal Reserve (Fed)continuing to raise rates will further alter the math associated with unprofitable/high-growth market segments
Uneven earnings sentiment: Nearly the same number of firm estimates are being upgraded as downgraded. Having declined every month over the past five, this ratio is far lower than it was one year ago (4.92)12
Elevated volatility: Cross-asset volatility decreases speculative market behavior. Investor’s tendency to favor defensive segments rather than higher beta market exposures is evident in fund flows and depressed trading volumes.
Reduction in liquidity: As the Fed has begun to wind down its balance sheet, both corporate and consumer cash levels have fallen.
These trends show a prominent shift from a narrative-driven market where “stock stories” featuring grandiose proclamations of revolutionary growth took precedence over actual sales to a fundamentals-led market. This has coincided with a reduction in liquidity (Fed balance sheet), cash stockpiles (consumer and corporations), and higher hurdle/financing rates for unproven firms (higher real rates).
Given this backdrop, it’s difficult to imagine narratives getting back into the driver’s seat anytime soon. As a result, investors may want to emphasize profitability over proclamations and target high-quality value in the core.
1 Bloomberg Finance L.P. as of June 8, 2022, based on stocks in the Russell 3000 Index with negative earnings-per-share versus those positive earnings-per-share from April 30, 2020, to April 30, 2021. 2 Bloomberg Finance L.P. as of June 8, 2022, based on the stocks in the Russell 1000 Index (Large Caps) and the Russell 2000 Index (Small Caps). 3 Bloomberg Finance L.P. as of June 8, 2022, based on the yield on the US 10 Year Treasury Inflation Protected Bond. 4 Bloomberg Finance L.P. as of June 8, 2022, based on the US 10 Year Yield. 5 Bloomberg Finance L.P. as of June 8, 2022, based on stocks in the Russell 3000 Index. 6 Bloomberg Finance L.P. as of June 8, 2022, based on the return of the S&P 500 Energy Sector Index. 7 Bloomberg Finance L.P. as of June 8, 2022, based on stocks in the Russell 3000 Index within the Consumer Staples Sector. 8 Bloomberg Finance L.P. as of June 8, 2022, based on stocks in the Russell 3000 Index. 9 Bloomberg Finance L.P. as of June 8, 2022, based on stocks in the Russell 3000 Index. 10 Based on the underlying holdings of funds classified by SPDR Americas Research as Broad Innovation funds within the thematic ETF marketplace as of June 8, 2022, per Bloomberg Finance L.P. data and SPDR Americas Research calculations. 11 Based on the underlying holdings of funds classified by SPDR Americas Research as Broad Innovation funds within the thematic ETF marketplace as of June 8, 2022, per Bloomberg Finance L.P. data and SPDR Americas Research calculations. 12 FactSet, as of June 8, 2022. Based on consensus analyst estimates. 13 “The Cash Burning Question”, Barclays Equity Research June7, 2022.
Russell 3000 Index The Russell 3000 Index is composed of 3000 large US companies, as determined by market capitalization. This portfolio of Securities represents approximately 98% of the investable U.S. equity market.
S&P 500 Energy Sector Index The S&P 500 Energy Sector Index is the GICS Level 1 sector index of stocks within the sector in the S&P 500 Index.
Global Industry Classification Standard (GICS) The Global Industry Classification Standard (GICS) is a method for assigning companies to a specific economic sector and industry group that best defines its business operations.
The views expressed in this material are the views of the SPDR Research and Strategy team through the period ended June 8, 2022, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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