It has been a rough several months for U.S. stocks. While broad market averages are down, they obscure the extent of the wreckage. Not even the technology-heavy Nasdaq Composite Index, which has tumbled more than the better-known S&P 500 Index and Dow Jones Industrial Average, tells the whole story.
What has happened is that glamour stocks — shares of highly valued, rapidly growing companies with little or no profits — have taken a beating: not a correction, not a bear market selloff but declines of a magnitude that typically accompany financial meltdowns and other crises. Many of the hardest-hit stocks have been those of companies trumpeted in the latest Wall Street lingo as “disruptive innovators” poised to achieve “exponential growth,” such as telemedicine company Teladoc Health Inc., streaming platform Roku Inc. and video-conferencing provider Zoom Video Communications Inc. Rarely mentioned is the data showing that glamour stocks are most often a losing bet.
Their recent collapse is truly staggering. I broke out the Russell 3000 Index — roughly the 3,000 largest U.S. stocks by market value — into quintiles based on analysts’ consensus profit margins for the current fiscal year. The median decline from 52-week high for the stocks in the most profitable quintile was 15% through last week. The losses deepen with each successive quintile, landing at a median decline of 59% for the least profitable group.
The results are similar when sorting companies on valuation. I also divided the Russell 3000 into quintiles based on last year’s price-to-book ratio. I’m using book value rather than earnings, cash flow or sales because hundreds of companies in the index lose money, and many of them bleed cash or have nominal or no revenue. The median decline from 52-week high for the cheapest quintile was 16%. And like profitability, the losses grow with each successive quintile, arriving at a median decline of 33% for the most expensive companies.
The historical record suggests this is not an anomaly. Since 1963, shares of the cheapest and most highly profitable companies have returned 15% a year, including dividends, according to numbers compiled by Dartmouth professor Ken French equally weighting companies sorted by price-to-book ratio and a variation of return on equity. Meanwhile, the priciest and least profitable companies have returned just 3% a year, roughly the same as cash. The low-valuation, high-profitability companies also won 87% of the time over rolling 10-year periods.
That makes sense. In the long run, stock investing is about earnings, and the game is to buy those earnings as cheaply as possible. Companies that are cheap and already highly profitable are the surest bet. Newer companies with lean profits might be hugely profitable down the road, but that potential is almost always baked into their high valuation. While some will live up to expectations, many will not, causing their valuations to deflate. And because no one can tell the winners from losers in advance, those who try are likely to end up with some of both, leaving them no better off.
Investors have been burned before. The 13% of rolling 10-year periods in which expensive, low-profitability stocks beat cheap, highly profitable ones are clustered around just two periods. Glamour stocks were in high demand during the late 1960s and early 1970s, as they have been in recent years. Then, as now, the convergence of innovation and a raging bull market enticed investors to chase fast-growing companies with little regard for profits or valuation. In the ensuing two-year bear market beginning in 1973, glamour stocks were hit hardest, and cheap, highly profitable companies blew past them in the years that followed.
Only this time the glamour binge runs far deeper. By September 2020, the most expensive and least profitable companies had outpaced the cheapest, most profitable ones by 15 percentage points a year during the preceding 10 years, nearly triple their highest outperformance during any comparable period during the 1960s and 1970s. They’ve given back much of those gains in recent months — their lead has dropped to 7 percentage points for the 10 years through 2021, and it has likely fallen further in recent weeks.
Some investors see in the recent declines the beginning of a larger reckoning for U.S. stocks. The reality is that the reckoning is already well underway and possibly mostly over. You just wouldn’t know it looking at the broad market averages.
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