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Is profitability and sales growth convergence alive?
This article takes the pulse of profitability and sales growth convergence. ‘Trees don’t grow to the sky’ is a classical proverb to describe there are limits to growth and improvement, but is the phrase outdated? With a decade of growth stocks outperformance behind us, to some this may seem so. To form a substantiated opinion, the following research article presents a factual analysis of the evolution in profitability and sales growth convergence.
The persistence in a company’s profitability and/or growth characteristics are important determinants for shareholder returns. When a company is active in a business segment with limited competition and high barriers to entry, its shareholders can probably look forward to a relatively persistent stream of attractive profits. Alternatively, if a company sells products that are highly commoditised, and it does not have any meaningful operating advantage, the expected profit stream likely looks comparatively meagre.
Enter for instance changing consumer preferences and/or innovation, and suddenly a company’s profitability persistence might not look the same anymore. Changing consumer habits can make the demand for the first company’s products falter and its profitability wane. On the other side, the second company might innovate and distinguish its products positively from its competitors’, paving the way for its profitability to improve.
Value investors often seek out companies of which they expect that their relatively modest profitability or growth will improve. To the contrary, quality/growth investors seek companies with a high persistence in attractive profitability or growth. Empirical evidence has shown that in doing so, they have on average been fighting against the tide though. Profitability and growth characteristics mean revert. Companies with a high profitability/growth are expected to see their profitability/growth advantage diminish over time and vice versa.
Profitability and growth convergence on average.
In this article, I investigate recent trends in profitability mean-reversion. The following approach is used: Top/bottom quartile portfolios based on return-on-equity (ROE) are formed -selecting stocks in every sector. Next, the difference in their respective ROE is tracked over a period of 10 years after the initial portfolio construction. This exercise is repeated at regular intervals in both the US and EMU equity universe, starting the analysis in December 2000. The first chart shows by how much the profitability spread between the top/bottom quartile portfolio converges over the years. Clearly, over the last two decades profitability convergence manifested itself. Moreover, it is surprising to see that the convergence follows a rather linear path through time: Convergence in the later years occurs at a similar rate than in the earlier years.
To specifically investigate the profitability convergence for value stocks and their more expensive counterparts, the same analysis was done for top/bottom quartile portfolios based on the price-to-book (PB) measure. The results confirm that also over the last two decades, the profitability of cheap and expensive value stocks converged in the years after their classification as being cheap or expensive. This convergence is less outspoken though than the convergence in profitability between the top/bottom quartile portfolios based directly on profitability.
Next, growth convergence is investigated by forming top/bottom quartile portfolios based on expected sales growth and then tracking their growth spread in the subsequent 10 years. Again, this exercise is repeated at regular intervals. Here, it turns out that -similar to profitability- sales growth has been converging on average as well over the last two decades. Compared to the profitability convergence, growth convergence has been happening at a higher rate in the earlier years after the formation of the top/bottom growth portfolios. It suggests that an investment strategy selecting stocks for which growth prospects are expected to improve, could bear fruit more quickly than a strategy selecting stocks for which the profitability is expected to improve.
Like we did for profitability, we now also investigate the sales growth convergence between cheap and expensive stocks. This time, we look at the evolution of the growth differential between the top and bottom quartile portfolios based on the price-earnings ratio (PE). Here also, the sales growth of cheap and expensive stocks has been converging. The convergence has been less impressive though than for the top/bottom quartile portfolios formed directly based on their sales growth.
Profitability and growth convergence evolution across the years.
Chart 1 and 2 show the average mean reversion in profitability and growth characteristics in the last two decades and how this evolved in the years after the initial portfolio formations. Now, we focus on the mean reversion that has taken place five years after the portfolio formation. For this metric, we look at the evolution over the last two decades. In the next charts we can thus for instance see if profitability mean reversion after five years has been stronger for portfolios formed in 2001, compared to portfolios formed in 2011. It turns out that indeed, profitability mean reversion has been relatively weak over the last ten years, compared to the first decade of the millennium. Moreover, profitability mean reversion is cyclical. Clearly, the profitability mean reversion is the strongest for top/bottom quartile portfolios formed at cyclical throughs. Ironically, this coincides with the exact moments when low profitability/value stocks are the cheapest in relative terms.
Regarding the profitability convergence between cheap and expensive stocks, it is notable that in the US this has been absent for cheap/expensive portfolios formed between 2012 and 2015. This is coherent with the weak performance of US value stocks up until 2020. In the EMU, profitability convergence between cheap and expensive stocks selected between 2012 and 2015 has also been low, but it remained present nonetheless. Recently, profitability mean reversion is increasing again, both in the US and the EMU. Current earnings forecasts revisions are also stronger for cheaper stocks than for their more expensive counterparts. This will certainly help to improve the profitability mean reversion.
Now, let’s look at the evolution of sales growth convergence through time -again 5 years after the initial portfolio formation. It also turns out that sales growth mean reversion has been relatively weak over the last ten years compared to the start of the millennium. Interestingly, sales growth convergence occurs across the cycle. It is not as cyclical as the profitability mean reversion shown above.
Sales growth convergence for EMU value stocks has been almost absent between 2012 and 2015. Recently it is better, but it stays modest and volatile.
The profitability and sales growth convergence have been relatively weak over the last ten years, especially for value stocks. Still, the evidence supports that mean reversion is alive, albeit more modestly. This could be due to the increasing importance of network effects and the competition supervisors’ implicit endorsement for regional champions that can carry the flag in the competition with players from other regions.
Finally, the analysis has an investment implication. As profitability mean reversion has been shown to be cyclical, we can expect mean reversion to increase in the years after the Covid-19 crisis. In fact, the increasing convergence already started to show up in the last figures. This, together with cheap relative valuations, better earnings forecasts revisions and a higher-inflation/ above-average economic growth environment are supportive arguments for a near term continuation of the value recovery.