Are corporate profits the key to weathering a stock slide?
PremiumThe data from bear markets suggests that companies’ ability to make money protects investors in turbulent markets
With the US stock market off to a shaky start this year, investors can expect to hear the old saws about declining markets: Active managers beat indexes in a bear market (they don’t); value stocks are hit hardest in a market slump (wrong again); or the subject of this column, that shares of high-quality companies offer the best shelter in a turbulent market.
Quality means different things to different investors, but by most definitions a high-quality company is one that makes a lot of money reliably. Think Apple Inc., Microsoft Corp. or Johnson & Johnson. In that sense, it’s reasonable to assume that shares of high-quality companies will fare best in a bear market because fat profits often come with a strong brand, loyal customers, good management and deep pockets, all big advantages in a downturn.
But is it true? One problem with poking around bear markets is that they don’t come along often, so there isn’t much data. I’m looking at numbers compiled by Dartmouth professor Ken French that stretch back to 1963, and I count only eight bear markets since then. Still, it’s worth examining whether shares of highly profitable companies truly did perform best during those episodes.
The results during the first four bear markets are mixed. I compared total returns for the most profitable 20% of U.S. companies, weighted by market value, with those of the least profitable 20%. During the two bear markets in the 1960s, the low-profitability stocks declined more than the higher-profitability ones, as one might expect. But in the ensuing two bear markets in the 1970s and early 1980s, the low-profitability stocks outperformed. In fact, the low-profitability group was up 10% during the bear market from 1980 to 1982, while high-profitability stocks declined modestly.
Looking at the record in the mid-1980s, investors would have had little confidence that higher profits translate into better protection in a bear market. But since then, high-profitability stocks have won every time, and by huge margins during the dot-com bust in the early 2000s and later during the 2008 financial crisis. That could be mere chance, although the data hints that something else may be going on.
By definition, the average profitability of highly profitable companies exceeds that of low-profitability ones. Even so, during the first four bear markets I looked at, the average profitability of the low-profitability group was still positive. During the ensuing four bear markets, however, their average profitability was always negative, which raises the possibility that it may not be the degree of profitability that provides protection but whether companies are making money at all.
There’s reason to believe that turning a profit— any profit — is the key. Looking at the stock returns of all quintiles by profitability during the eight bear markets, higher average profitability has not necessarily translated into better performance. But every time average profitability was negative, as it was for the least profitable 20% of stocks in each of the past four bear markets, the performance of that group was consistently the worst.
If making money is the difference in a bear market, it’s a problem for a growing number of companies. In January 1996, the first month for which numbers are available, 12% of the companies in the Russell 3000 Index — roughly the largest 3,000 U.S. public companies by market value — lost money during the preceding 12 months. By the peak of the dot-com bubble four years later, that number had risen to 18% and was only modestly lower at the peak of the next bull market in 2007.
Fast forward to 2019. After a decade long bull run and the second longest on record, the percentage of Russell 3000 companies that lost money in the preceding 12 months jumped to 29%. Now, two years into the market’s meteoric rise from the Covid selloff in 2020, a third of companies are unprofitable. And yes, the average profitability of the least profitable 20% of U.S. stocks is still negative.
It's easy to overlook profits when a rising market is lifting all stocks. But a declining market has a way of reminding investors that companies are supposed to make money, and there are signs that investors are already getting the message. Since the market began its descent in early January, shares of Russell 3000 companies that made money last year are down by an average of 7%, while those that lost money have declined by an average of 16%.
There’s too little data to say with confidence that profits will better protect investors during the next bear market. But there’s enough evidence to suggest they could, and with the huge number of unprofitable public companies in the U.S., it’s a good time for investors to assess the quality of their stock portfolios.
Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.
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