Bizarre stock market strategy has been hugely profitable, still going

Reuters / Lucas Jackson

• A stock-trading strategy that involves buying shares of
  money-losing Russell 2000 companies has crushed benchmarks so
  far this year.
• If historical precedent is any indicator, the
  outperformance should continue for the foreseeable
  future.

Investing in money-losing companies would seem to defy
traditional logic. But if you’ve been doing it, chances are your
portfolio is sitting pretty.

That’s according to Leuthold Group, which finds that
unprofitable companies in the 2,000-stock small-cap universe have
surged an average of 14.5% this year. That dwarfs both the 9.2%
return seen by their money-making counterparts and the 10.9%
return for the entire Russell 2000 index.

It’s relatively easy to replicate this success. All you have to
do is screen the Russell 2000 for the companies whose bottom
lines have been in the red over the past 12 months, then load up
on shares.

As the chart below shows, as of right now, 31% of companies in
the Russell 2000 have lost money over that period — so you have
quite the selection if you wish to adopt this strategy.

Leuthold
Group

With that in mind, the chart raises questions. Most notably: How
has the percentage of money-losing companies stayed so high in an
environment characterized by full employment and slow wage
growth? Considering that the measure was in this rarefied air
around the past two bear markets, this would seem to signal
impending doom.

Not so fast, says Leuthold, which believes we’re dealing with a
unique set of circumstances right now. For one, the number of
listed companies has shrunk as profitable but underleveraged
firms have been snapped up in acquisitions.

Secondly, the historically-easy lending conditions that have
underpinned the more than nine-year bull market has played a role
in keeping the shares of unprofitable companies afloat.

“Extremely loose monetary policy has kept alive corporate
‘zombies’ which might have perished in a normal interest rate
environment,” Doug Ramsey, Leuthold’s chief investment
officer, wrote in a client note. “While the term zombie might be
an inappropriate one for, say, a small biotech with a high burn
rate, there’s certainly evidence that extremely low interest
rates have subsidized (if not incented) the perennial money
losers.”

So what’s next? Is this strategy sustainable over the longer
term?

Leuthold says the coast is clear, at least for now. In order to
arrive at that assessment, the firm compared the share of
money-losing companies in the Russell 2000 to the real 3-month
Treasury bill rate.

The two measures have exhibited an inverse relationship over
time. Put differently, the lower 3-year borrowing costs have
been, the more unprofitable companies there have been.

According to Leuthold’s analysis, the 3-month rate has to climb
all the way to 3.5% for there to be a trough in money-losing
stocks. Considering it’s currently sitting below 2%, it should
remain open season on the dogs of the Russell 2000 for a while
longer.

Leuthold Group