By Derek Horstmeyer | Graphics by Vanessa Qian 

Uber, 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 quarters ended Sept. 30, 2019.

While some of these unprofitable companies may be perceived as disrupters of future business and embraced by certain investors, 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 investing in, say, an Amazon.com, when the 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 volatile 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 disclosing 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 "profitable," 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 returns calculated.

First, the shares of unprofitable companies have vastly underperformed those of profitable companies over the past five years. No surprise there. Among the profitable companies, the median annualized share return was 16.0%, compared 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 companies was twice as high as it was for the profitable companies over the past five years (standard deviation 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 equity investors don't pay that much attention to this data point. Rate increases 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 following each of the nine rate increases in the past five years, the returns of unprofitable companies fell an average of 2.2%, compared with 0.8% for profitable companies. This highlights that unprofitable companies are much more sensitive to Fed rate increases than profitable compares are.

All in all, even though younger investors 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. Horstmeyer is an associate professor of finance at George Mason University's Business School in Fairfax, Va. He can be reached at reports@wsj.com.

 

(END) Dow Jones Newswires

March 08, 2020 23:21 ET (03:21 GMT)

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