By Chris Satterthwaite, CFA, Senior Analyst, at Verdad.

 

Low profitability, high investment stocks are on a tear

Garbage stocks are back! The release of ChatGPT and the enthusiasm around artificial intelligence has led to a massive rally in unprofitable tech companies. ARKK, which captures l’esprit du jour of AI investing even more precisely, is +22% YTD. Other more AI-related stocks are up significantly more (NVDA +90%, AI +60%). These results have far outpaced the 6% return of the S&P 500 and the 14% return of the NASDAQ, which is dominated by more mature (and profitable) tech companies.

These hype-driven rallies around narrative themes have become a dominant feature in the US equity markets, most recently during the COVID-era meme stock frenzy. As we wrote about in the Bubble 500, we believe the golden age for these garbage stocks was 2018–2021. But garbage suffered a brutal reversal in 2022, as rising interest rates sobered equity investors into focusing more on long-forgotten metrics like free cash flow, dividends, and profitability.

The rising tide of AI has buoyed spirits in certain public equities. Search interest for “AI stocks” recently hit an all-time high, and we see daily articles about the VC frenzy to invest in AI-related companies:

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Previous “peak search engine” equity rallies have not ended well. This phenomenon played out numerous times throughout the 2000s as trends came and went, as illustrated below.

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In defense of AI, we have found ChatGPT useful in helping outline and debug code, summarize academic research, and help automate tedious labeling tasks. Nevertheless, the large-scale positive benefits from AI will likely take longer to materialize and have more modest applications and scope than today’s AI evangelists (and doomsayers) would lead us to believe. As the lighthearted example from Excel shows below, AI has a long way to go.

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More generally, academic research has found that stocks with low profitability and high investment tend to be the market’s worst performers. Equities at the intersection of low profitability and high investment are often moonshot bets that are perhaps better suited to the cover of Popular Science than standalone public equities. Companies like Virgin Galactic (SPCE), Danimer Scientific (DNMR), or NuScale Power (SMR) are all working on exciting future technologies that are many years away from monetization, with a high likelihood of disappointments along the way.

Long-term US equity factor research by Ken French shows that some categories of stocks do uniquely badly. Below, we show two 2x2 matrices, one a classic size x value grid and the other a grid of profitability and investment. The smallest, cheapest stocks have long earned a premium, while unprofitable companies making significant investments have tended to perform the worst.

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Today, the top 100 ranked US garbage stocks by low profitability and high investment have lost $10B of EBITDA on $37B of sales in 2022 and trade at a median 9.9x TEV/sales. Garbage stocks are on a tear: but will it last?

Original article

About the Author:

Before joining Verdad, Chris Satterthwaite worked at Philosophy Capital, where he was an Analyst covering long/short equity and credit. Prior to Philosophy, he worked at Stadium Capital and the Boston Consulting Group. Chris earned an AB from Harvard College, where he was Captain of the Harvard Men’s Swimming & Diving team, and an MBA from the Stanford Graduate School of Business. In addition, Chris is a CFA charterholder.

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