A recent opinion piece by Ian McGugan in The Globe and Mail* highlighted a dubious distinction for Canada: it has the highest proportion of unprofitable listed companies in the world, according to research by Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University. Based on Damodaran’s calculation of negative net income based on an equal-weighted metric, Canada topped the list with 75% of public companies failing to meet this measure of profitability, well above the U.S. with 45% and the global average of 30%.
Source: The Globe and Mail; Aswath Damodaran, January 27, 2019: Data Update 6: Profitability and Value Creation. https://aswathdamodaran.blogspot.com/2019/01/january-2019-data-update-6.html
There can be good reasons for a quality business to show, from an accounting perspective, a loss for a certain time. This can include being an early-stage growth company making significant investments. Specific accounting conventions can be punitive for certain type of businesses. Often, however, there are businesses or entire industries which, almost without fail, generate poor or negative returns. These companies rely on the generosity or wishful thinking of capital providers, plus a little help from investment bankers to keep them going.
While the Canadian stock market has many positive characteristics and outstanding businesses, it also has many “lower-quality” companies that can lead to greater risk if one owns the index. But before panicking about your Canadian holdings, keep in mind the Canadian stock market has historically been heavily weighted towards the volatile natural resources sector – a fact that underscores the importance of a diversified and well-managed portfolio.
The Cambridge portfolios are constructed using a bottom-up approach, which results in a high active share compared with competitors. The Cambridge team manages several Canadian equity funds and focuses on opportunities to provide strong risk-adjusted returns for Canadian investors. For example, Cambridge Canadian Dividend Fund is 96% invested in companies that were profitable in terms of net income in 2018.1
When one invests in the market, you are signing up to own a piece of each company in the index. One could ask: Could an unprofitable business turn into the next prominent, highly profitable global leader? Could a company that consistently fails to generate a sufficient return on capital, with a stretched balance sheet, volatile end markets, weak business economics and a poorly incentivized management team, suddenly turn the corner and begin creating substantial shareholder value? While both are technically possible, I suspect investors would be better off approaching these situations with caution.
A recent study2 from New York-based consulting company Kailash Capital compared the performance of profitable and unprofitable companies during periods of market stress. Not surprisingly, listed companies that were profitable experienced less than half the downside faced by their money-losing counterparts. The research by Kailash also found that the critical element to compounding value at the highest long-term rate is to minimize impairments to capital. At Cambridge, we believe that focusing our time and our clients’ capital on high-quality profitable companies can reduce the risk of “compounding interruptions”.
What makes Cambridge excited about the value we can generate in Canada, for Canadian investors, is the fact that we focus our time and effort. By selecting companies that can generate long-term shareholder value, we believe we have a greater chance of sustainable success right out of the gate. By carrying out deep due diligence on a company’s business prospects, we get to know them from the perspective of a business owner which helps us make an informed investment decision to minimize loss, reduce volatility and maximize potential gain.
It is because the Canadian market is characterized by so much disparity in the quality of companies that investors can benefit from a true active management approach instead of mirroring an index. We appreciate the continued support of our clients. Investing on your behalf is a great privilege and responsibility.
*“OPINION: Why investing in the Canadian stock market is riskier than you think,” By Ian McGugan, January 23, 2019.
1. The one unprofitable holding (4% position) lost money due to hedging activities. The business did, however, generate strong underlying cash flow.
2. Better a Seller than a Buyer Be?” – Kailash Capital – February 3, 2019. The study looked at Russell 2500 companies.
Stephen Groff is a Portfolio Manager to certain Cambridge funds. He does not have a material interest in the securities discussed herein; however, he is an investor in certain Cambridge funds which may hold these securities.
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Published February 22, 2019