R8| Monday, March 9, 2020 THE WALL STREET JOURNAL.

ALICIA TATONE

uity investors don’t pay that much

attention to this data point. Rate in-

creases typically have more direct

consequence for bond investors;

when interest rates rise, the value of

bonds purchased earlier tends to fall.

For stocks, meanwhile, although rate

increases tend to be seen as putting

an immediate drag on earnings in

general, for the five years I studied,

the unprofitable companies showed

50% greater interest-rate risk than

profitable ones.

To be precise, for the 30 days fol-

lowing each of the nine rate in-

creases in the past five years, the re-

turns of unprofitable companies fell

an average of 2.2%, compared with

0.8% for profitable companies. This

highlights that unprofitable compa-

nies are much more sensitive to Fed

rate increases than profitable com-

pares are.

All in all, even though younger in-

vestors might like these unprofitable

companies, the historical evidence

paints a much bleaker picture—

greater interest-rate risk, volatility

and general underperformance all

add up to not the best thing to add

to one’s portfolio.

Dr. Horstmeyeris an associate

professor of finance at George

Mason University’s Business School

in Fairfax, Va. He can be reached

[email protected].

Unprofitableandprofitablecompanies’

breakdown by return performance

Source: Derek Horstmeyer, George Mason University

Notes: Profitability is based on average net income over

assets over 2018. Performance is based on geometric

returns over 2019.

negative returns

unprofitable profitable

nonnegative returns

53%

47% 22%

78%

JOURNAL REPORT |INVESTING IN FUNDS & ETFS

chips were down, in most cases the

stocks of unprofitable companies

eventually head in one direction:

lower.

These companies exhibit greater

risk than profitable companies

across the board: Their shares on

average return less, are more vola-

tile and are prone to a type of risk

more typically associated with

bonds—interest-rate risk.

Taking the full set of all NYSE-

and Nasdaq-listed companies dis-

closing earnings for the past five

years, and using the cumulative net

income over the prior four quarters

in a given year, I deemed those

with positive net income as “profit-

able,” and those with negative net

income as “unprofitable.” To avoid

any look-ahead bias in the data,

measures of profitability were

based on the year preceding the

start date of any one-year stock re-

turns calculated.

First, the shares of unprofitable

companies have vastly underper-

formed those of profitable compa-

nies over the past five years. No

surprise there. Among the profit-

able companies, the median annual-

ized share return was 16.0%, com-

pared with 4.2% for the

unprofitable firms. This amounts to

an annualized difference of 11.8

percentage points.

That the average share return of

the unprofitable companies was

positive at all will perhaps surprise

some. But this can be attributed to

two things: One, there are a lot of

shareholders who don’t want to

miss “the next big thing,” so they

bet on the riskiest companies; and

two, markets are imperfect.

Next up, volatility. Unprofitable

companies as a group were far

more volatile than their profitable

counterparts. In fact, volatility

for the unprofitable com-

panies was twice as high as

it was for the profitable

companies over the past

five years (standard devia-

tion in returns of 59.3% v.

29.2%).

And, finally, interest-rate risk,

or, how returns were affected each

time the Fed raised rates. Most eq-

We ran the numbers, and the

picture is a bleak one, despite

some high-profile successes

The Allure

And Risk of

Unprofitable

Companies

U

ber , Pinterest , Peloton ,

Lyft , Snap —the list of

unprofitable companies trading

on U.S. exchanges is a long

one.

In fact, of listings on the

New York Stock Exchange and Nasdaq with

at least one year of the relevant earnings

data, more than 35% were unprofitable in

their cumulative results for the four quar-

ters ended Sept. 30, 2019.

While some of these unprofitable compa-

nies may be perceived as disrupters of fu-

ture business and embraced by certain in-

vestors, most of their shareholders probably

don’t fully realize the set of risks they are

taking on. Indeed, while there will always be

investors who wind up looking smart for in-

vesting in, say, an Amazon.com, when the

BYDEREKHORSTMEYER

35%ofNYSE

and Nasdaq

stocks can

be called

unprofitable.

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