Corporate profits

Are corporate earnings the key to resisting a stock decline?

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 stocks of high-quality companies will fare better in a bear market, because big profits often come with a strong brand, loyal customers, good management and deep pockets, all big upsides in a downturn.

But is it true? One problem with bear markets is that they don’t happen often, so there isn’t a lot of data. I look at the numbers compiled by Dartmouth professor Ken French dating back to 1963, and I’ve only counted eight bear markets since then. Nevertheless, it is worth examining whether stocks of highly profitable companies have really performed better during these episodes.

The results of the first four bear markets are mixed. I compared the total returns of the 20% most profitable US companies, weighted by market value, with those of the 20% least profitable. During the two bear markets of the 1960s, low-profit stocks declined more than high-profit stocks, as might be expected. But in the two bear markets that followed in the 1970s and early 1980s, low-profit stocks outperformed. In fact, the low-profit group rose 10% during the bear market from 1980 to 1982, while the high-profit stocks fell slightly.

Looking back to the mid-1980s record, investors would have had little faith that higher earnings translate to better protection in a bear market. But since then, high-profit stocks have won every time, and by huge margins during the dot-com meltdown of the early 2000s and later during the 2008 financial crisis. It could be a simple chance, although the data suggests something else is going on.

By definition, the average profitability of highly profitable companies exceeds that of less profitable companies. Even so, in the first four bear markets I looked at, the average profitability of the low-profit group was always positive. In the four subsequent bear markets, however, their average profitability has always been negative, suggesting that it may not be the degree of profitability that provides protection, but whether companies are gaining money.

There’s reason to believe that making a profit – any profit – is key. Looking at the stock returns of all quintiles by profitability during the eight bear markets, higher average profitability did not necessarily translate into better performance. But whenever the average return was negative, as was the case for the bottom 20% of stocks in each of the last four bear markets, that group performed 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 figures are available, 12% of companies in the Russell 3000 Index—about the 3,000 largest U.S. public companies by market value—lost money in the 12 months previous ones. At the height of the dotcom bubble four years later, that number had risen to 18% and was only slightly below the height of the next bull market in 2007.

Fast forward to 2019. After a decade of rises and the second longest on record, the percentage of Russell 3000 companies that lost money in the previous 12 months rose to 29%. Now, two years after the market’s meteoric rise since the Covid sell-off in 2020, a third of businesses are unprofitable. And yes, the average return of the 20% least profitable US stocks is still negative.

It’s easy to overlook profits when a rising market drives all stocks up. But a declining market reminds investors that companies are meant 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 have fallen an average of 7%, while those that lost money have fallen in average of 16%.

There is too little data to say with certainty that earnings will better protect investors in the next bear market. But there’s enough evidence to suggest they might, and with the large number of unprofitable public companies in the United States, now is a good time for investors to assess the quality of their investment portfolios. actions.

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management company. He worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.