Lessons from 40 years of company returns

Global equity markets aren’t perfectly efficient. There are persistent pricing anomalies that open up rewarding investment opportunities for patient, rigorous and informed investors – particularly those who have a methodical, quantitative approach, like Pictet Asset Management's Quest range of equity strategies. One such anomaly is the market's repeated misread of a firm's ability to sustain profits over the long run, which is an important source of return in equity investing.

We ran an analysis of corporate profitability across global equities and found that firms with robust return on equity (RoE) outperform market indices and do so with less volatility.

The study looked at corporate RoE over the period from 1986 to 2023, breaking the market down by company size, region and industry; all three factors have played a role in profit variability under different environments. 

Mispricing risk

Risk is consistently mispriced by the market, enabling investors who can identify these mispricings to harvest attractive risk-adjusted returns. We are agnostic about why these anomalies exist – they could be due to behavioural biases or other factors – but our research shows that they are pervasive and persistent.

How the global equity market developed over nearly 40 years gives an indication of where to be positioned now in light of US policy volatility and the risk that persistent inflation forces central banks to keep rates higher for longer.

Our analysis is based on 20,000 globally listed public companies – primarily excluding micro-caps, which, despite making up 50% of all listed companies, represent a mere 1% of total market capitalisation and are highly illiquid.

Looking at the universe of stocks as a whole, profitability as measured by return on equity (net income divided by common equity) has ranged between 4% and 14%, mostly trending around 10% over the period. Lows were notched up during the Internet bubble, the global financial crisis (GFC) and the Covid pandemic. But even though profitability was broadly stable, productivity has grown sharply in that time, thanks to the Internet and the secular downtrend in interest rates.

Breaking the data down by region shows that while the Asian crisis of 1998 had a major impact on emerging market companies, businesses in the developed world were largely unaffected. By contrast, emerging economies were relatively immune to the Internet bust, the GFC and Covid, compared with the big slumps in profitability in the developed world.

Among sectors, unsurprisingly, information technology was hard hit by the Internet bust, while real estate suffered most during the GFC, burdened by rising interest rates. It’s worth bearing in mind that real estate is once again suffering a big slump in profitability – could it be a canary in the coal mine for the rest of the economy?

Broken down by market capitalisation, the biggest firms – the top quartile by market capitalisation – not only had the strongest profitability but were also most resilient to market shocks. By contrast, the smallest capitalisation stocks struggled most with generating return on equity.

Indeed, rising profit margins mostly accrued to mega- and large-cap companies during the period (see chart). Some of that will have been due to economic moats – the biggest companies have the best defences against competition, either through intellectual property rights or capital cost barriers to entry. But it will also have been down to declining interest rates over the period, which dragged down debt servicing costs, thereby lifting margins. Another tailwind was falling tax rates, not least during Donald Trump’s first administration. He’s promised to cut taxes further – but how long low corporate tax rates can be sustained against a backdrop of big fiscal deficits is another question.

Elsewhere, our analysis suggests that investors pay special attention to companies with bloated assets, given ample evidence that ones that allow their balance sheets to grow quickly tend to be poor investments.

Revenues relative to assets have shrunk over time as companies have been increasingly willing to buy businesses above their net fair value.

Financial leverage is less of a concern than in the past thanks to falling interest rates, but that could yet reverse. And while there’s been convergence in profitability between developed and emerging market profitability over time, there’s still a gap between the large and small caps.

This research builds our understanding of profitability, leverage and valuation across regions and sizes of companies. This benefits Picet Asset Management's Quest sustainable strategies, which aim to deliver long-term outperformance and lower drawdowns by identifying companies that are profitable, prudently managed, protect on the downsid and are attractively priced.