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Navigating the Current Equity Landscape

Navigating the Current Equity Landscape with an Emphasis on High Profits and High Growth Reopening and inflationary themes conjure many competing narratives on the proper way to build portfolios or allocate capital in preparation for the ongoing shift in investor preference. It is often stated that inflation will benefit value stocks by diminishing the present value of distant future cash flows delivered by long duration growth stocks with low or negative profits today (we recently reviewed this in more detail in this article). Another theme related to “zombie companies” warns of low profit firms that are only able to cover their interest burden while interest rates remain historically low. In the current marketplace, this term has been applied to low profit, startup investments, but low profit and high leverage tends to be the domain of value traps when forming portfolios on Russell’s style methodology. While anecdotal evidence abounds regarding low profit stocks that benefitted from overcrowding during the investor rush towards COVID/WFH themes, we have aggregated data across independent sorts of a multifactor composite aligned to Russell’s style convention and various profitability measures to study this theme in aggregate.

This study also provides relevant insight regarding the role of profitability and growth in wealth creation; while AFG believes this concept is evergreen, there appears to be outsized benefit for investors to emphasize profitable, growing firms in the current investment landscape given the valuation agnosticism that has run rampant in investors.

In the Russell 1000, Growth+Hi Profit contains half of the overall index by market cap, including roughly 270 index constituents. These stocks merge growth characteristics with high levels of profits, and in aggregate have a cap[1]weighted intrinsic value % upside close to 18% (when measured with Economic Margins). The remaining basket of all other stocks has cap-weighted upside of -20%. This theme is consistent when building analysis on Fama French’s measure of Operating Profitability instead.

In the Russell 2000, these themes persist, although Growth+Hi Profit only reflects roughly 1/3 of the overall index’s market cap.

Wealth Compounding stocks (High Profits + High Growth) offer attractive upside to their index peers, and this approach will avoid “zombie” companies and long duration stocks that may struggle to keep pace with overall markets if inflation or cost of capital increases.

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Authors

  • John Holt, CFA joined Applied Finance in 2014 and is involved in the management of both quantitative strategies and analyst driven strategies.

  • Derek Bergen, CFA – Applied Finance Partner  Joined Applied Finance, 2005. Portfolio Manager and Quantitative Research Analyst. B.S. University of Wisconsin-Madison.

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