It Pays to Prioritize Profitability

Participate in financial markets long enough and one will eventually realize, like the world of high fashion, each season has a style.

Alright, so some liberties are being taken with that statement, but the point is what’s in favor in equity markets is often a fluid situation. With growth stocks outperforming in 11 of the 15 calendar years prior to 2022, some novice investors may think what’s in style in financial markets doesn’t change all that much. In reality, it does.

Think back to the 2020 rebound from the coronavirus bear market – recent history by market standards. That epic rally received significant contributions from junk stocks, or the shares of companies that aren’t profitable. The COVID-19 resurgence is just one example, but history is littered with instances of shares of money-losing companies leading markets higher.

Fast-forward to 2022 and to put it delicately, this isn’t the time to embrace unprofitable companies. As much was warned about in this space earlier this year. These days, profits are a priority and ignoring them is perilous for investors’ financial health.

Epic Divergence

May is just one month, but in the fifth month of 2022, profitable stocks enjoyed a 6.6% advantage over their money-losing counterparts. Since June 2021, shares of profitable companies beat their unprofitable rivals in 11 of 12 months. In other words, this writing has been on the wall.

“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,” notes Matthew Bartolini, head of SPDR Americas research.

In a market environment that’s placing an emphasis on profitability and overtly signaling to investors that unprofitable companies are out of style, it’s not surprising that the more profitable a company is, the better its shares are performing.

The average return for the top quintile of profitable stocks -5.6%, falling to -6.6% for the second quintile, according to State Street research. The bottom quintile, which is of course, littered with money-losing names, has an average return of -32.7%.

Sector Surprisingly Unimportant

Some sectors, more than others, are known for being bastions of quality. For example, the S&P 500 Quality Index allocates almost 58% of its weight to just two sectors – technology and financial services. However, markets aren’t playing sector-level favorites when it comes to the profitable/unprofitable debate.

Regardless of sector, shares of profitable firms are outpacing their money-losing equivalents. Still, there are some sectors where investors more of an emphasis on profitability than others. Those are consumer staples, healthcare and materials.

As Bartolini points out, profitable companies are topping money losers in 90% of industry groups this year, confirming it pays to prioritize profitability.

“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,” concludes Bartolini.

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