I have a stock to sell you. It costs a fortune. The company has never made money. In fact, it lost $1.8 billion last year. But it has millions of customers around the world, and it could become one of the most successful companies of all time. All you have to do is roll the dice.
That, in a nutshell, is the pitch Uber Technologies Inc. will make to potential investors in the coming weeks on the way to a highly anticipated initial public offering in May.
Uber isn’t alone. Its ride-hailing rival, Lyft Inc., went public in March with a hefty price backed by big expectations and steep losses. And a number of richly valued but profit-challenged companies are expected to go public this year, including digital scrapbook company Pinterest Inc., food-delivery company Postmates Inc. and messaging startup Slack Technologies Inc.
If Lyft’s oversubscribed IPO is any indication, there will be plenty of interest in shares of Uber and its cohorts, which is the exact opposite of what financial economists say investors ought to buy if they aspire to beat the market. According to the academic consensus, cheap and highly profitable companies are the better bet. Indeed, Warren Buffett and numerous other hall-of-fame investors such as Peter Lynch and Bill Miller exploited that formula for decades.
There’s a newfound suspicion among investors, however, that the consensus is out of touch. The timing couldn’t be better for Uber and its fellow debutantes. But before investors buck the consensus and chase this year’s hot IPOs, it’s worth thinking about whether this time is likely to be different.
It’s probably no accident that investors’ skepticism coincides with a period when cheap and highly profitable companies have been a bust. According to data compiled by Dartmouth professor Ken French, shares of the most expensive and least profitable U.S. companies, weighted by their market value, outpaced the cheapest and most profitable companies by an astounding 9.1 percentage points a year over the last 10 years through February, including dividends. They also beat the S&P 500 Index by 4.7 percentage points a year, and precious few investments have outpaced the mighty S&P during the last decade.
But look further back, and it’s an entirely different picture. The most expensive and least profitable companies lagged the S&P 500 by 7.2 percentage points a year from July 1963 to February 2019, the longest period for which results are available, and would have been worse without the last decade’s performance. They beat the S&P 500 one time over rolling 10-year periods through 2012, counted monthly (you guessed it, near the peak of the dot-com mania in February 2000). And overall, they outpaced the S&P 500 just 13 percent of the time over all rolling 10-year periods, again thanks only to their recent winning streak.
Meanwhile, the cheapest and most profitable companies have beaten the S&P 500 by 3 percentage points a year during the full period, and 72 percent of the time over rolling 10-year periods, despite their recently disappointing performance.
The question, of course, is whether the last decade is a better barometer than the four decades that preceded it. Many believe it is. Now that everyone knows cheap and highly profitable companies have historically been the better performers, the argument goes, investors are piling into their stocks, driving up prices and diluting future returns — and giving a boost to long shots such as Uber in the process. A new paper by economist Alex Horenstein lends some evidence to the theory.
There are a few problems, however. For one, it’s not clear that investors are listening to economists. Consider that value and quality exchange-traded funds, which invest in cheap and highly profitable companies, respectively, took in a combined $126 billion from 2008 to 2018, according to Bloomberg Intelligence. At the same time, ETFs that buy the broad market collected 12 times as much, or roughly $1.5 trillion.
It’s also not clear that the publication of data in the 1990s showing the superior performance of cheap and highly profitable companies has had much impact on their subsequent performance. They both outperformed and underperformed expensive and low-profitability companies at various time over rolling 10-year periods from 1973 to 1990, and the same has been true since then.
And the theory defies intuition. It makes sense that buying highly profitable companies for a reasonable price or cheaper would be a profitable venture. It also makes sense that chasing popular companies that don’t make money will most likely prove to be a costly indulgence because many of them will fail. That’s not an ironclad rule, but it should be true most of the time, and the numbers show that it has.
I can already hear the response: “Your analysis assumes an average investor that indiscriminately buys the most expensive and least profitable companies. But I’m not an average investor; I pick the winners!”
It’s tempting to think so. Identifying in advance the companies in this year’s crop of IPOs that will go on to become the next Microsoft, Amazon or Google would be hugely profitable, a far greater payoff than the humble expected premiums from cheap and highly profitable companies. As long as investors can’t resist trying, those cheap and highly profitable companies are likely to keep their edge.
To contact the author of this story: Nir Kaissar at firstname.lastname@example.org
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Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.
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