JUSA - Rise In Unprofitable Companies: Active Management's Time To Shine

2023-06-10 05:15:00 ET

Summary

• The percentage of unprofitable companies is increasing due to the Federal Reserve's aggressive hiking cycle, increased labor costs, and elevated inflation.
• Small- and mid-cap companies have underperformed during economic weakness, but their current valuations present potential outperformance opportunities for long-term investors.
• Active managers can help identify stable small- and mid-cap firms that can maintain topline growth and withstand the volatile period ahead.

The percentage of unprofitable companies is on the rise, largely thanks to the Federal Reserve’s aggressive hiking cycle, increased labor costs, and elevated inflation. While small- and mid-cap companies have been hit especially hard, their valuations remain attractive relative to large-caps. This presents a potential outperformance opportunity for long-term investors who can rely on an active manager to identify the companies that can maintain topline growth and withstand the volatile period ahead.

Percentage of unprofitable companies 2003–present

Source: FactSet, Principal Asset Management. Unprofitable companies measured by negative P/E NTM. Data as of May 31, 2023.

Historically, small- and mid-cap companies have underperformed their large-cap peers during periods of economic weakness—with recessions acting as ‘pruning events,’ sending the weaker companies to their demise. While the brief 2020 recession was an exception (the speed and magnitude in which liquidity flooded markets not only allowed most unprofitable companies to survive, but to thrive), a repeat of that is unlikely. In fact, the recent high-profile regional bank failures and retail bankruptcies have fully exposed the risk of higher rates and flawed business models.

Current valuations reflect these risks, with U.S. large-cap price-to-earnings looking expensive compared to historical averages and their small- and mid-cap counterparts. And with most pundits predicting a recession in the second half of 2023, large-cap stocks may be the best spot for investors in the short term.

However, the attractive valuations within the small- and mid-cap space can create opportunities. Since the performance of these companies bifurcates between profitable businesses that generate strong free cash flow and can maintain topline growth and those with weak competitive advantages and balance sheets, selectivity in the asset class remains essential.

Long-term investors would be well suited to seek out active managers who can successfully identify the stable small- and mid-cap firms best positioned to handle the near-term volatility.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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