Looking at the Rise of Money Losing Companies

Looking at the Rise of Money Losing Companies

By Jack Forehand, CFA, CFP® (@practicalquant) —

Two weeks ago, I wrote an article where I looked at the valuation of the median stock and how it has changed over time.  When I performed a simple median calculation and ordered all stocks in our universe by their PE ratios, the end result showed that the median stock is actually very cheap right now.

This is the chart I included in the article to illustrate that.

But one of the challenges I pointed out in using median data is that there are many more money losing companies right now than there were at the beginning of the period. Since those companies are excluded from a median calculation, that can distort the results.

To illustrate how significant the change has been, I included this chart.

The rise of unprofitable companies from 10% of the universe to 25% over 16 years is a significant one and seems like cause for concern. But as was pointed out to me on Twitter after I posted the data, that simple chart can be misleading because it doesn’t get at the reasons why it has happened.

So I thought it would be interesting to take a look behind the scenes to see if we can figure out more about what is causing this.

Here are a few interesting observations.

The Problem is Much Bigger in Small-Caps

One of the issues with the overall data that was pointed out to me by the user Jake @ Econompic on Twitter is that the problem is much bigger in small-caps. And he is 100% correct about that. As you can see in the chart below, if we look at just large-cap stocks, there is still an increase, but it is much less pronounced.

Year End DateNegative Earner Percentage

This is important to understand for investors who own market cap weighted funds because the earnings of the larger companies are far more important to these indexes than the earnings of smaller companies are. For example, Apple’s earnings play a much bigger role in the S&P 500’s earnings than the 500th company’s do. So what might seem like a major issue for investors based on my first chart is far less of an issue for many investors.  

Losing Companies are Concentrated in Specific Industries

Another issue that was pointed out on Twitter in looking at the overall data is that the rise in money losing companies is largely driven by two industries, Software and Biotechnology. This also turns out to be true.

Here is the percentage of money losing companies in those two industries over time.

Year End DateNegative Earner Percentage

As you can see, it has risen substantially and is now over 50%. That has driven much of the overall increase.

Earnings Don’t Tell You Everything

It is also important to keep in mind that earnings as a metric can be deceiving. That is a lesson of lot of us who are value investors learned when we misjudged companies like Amazon that were losing money on paper, but had very strong businesses beneath the surface. And with intangible assets rising in the economy, standard earnings calculations are becoming less and less accurate. So a rise in money losing companies isn’t as bad as the data may suggest.

In the end, the rise of unprofitable companies is certainly something to keep an eye on. But like most data, the devil is in the details and a look behind the scenes shows that there is much more to the story than the headline would suggest.

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.