The profit paradox: Why unprofitable small-caps are leading the stock market

Amid a roaring bull market, U.S. stocks have taken a surprising turn: unprofitable companies are outperforming profitable ones, a sign that investors may be taking on more risk in search of bigger returns.

According to Apollo’s chief economist Torsten Slok, since Trump’s “Liberation Day” tariffs, companies with negative earnings per share (EPS) have outperformed those with positive EPS within the Russell 2000 index of small-cap stocks.

As of October, 1,120 Russell 2000 firms reported positive EPS, compared with 806 reporting negative EPS, Apollo data showed.

“Something remarkable is going on in the equity market,” Slok noted, pointing to the rising popularity of unprofitable companies.

The counterintuitive trend underscores a risk-on sentiment among investors, who appear more willing to back speculative or high-growth companies despite weak fundamentals. Analysts warn that if this pattern continues, it could raise concerns about the overall quality and sustainability of the small-cap rally.

Commenting on the broader implications, economist Mohamed El-Erian said, “This can be seen as part of a broader phenomenon in which some investors are reaching further and further for returns, pushed there by the widespread compression in risk premiums.”

This isn’t the first time analysts have warned about the risks of unprofitable companies outperforming. Some suggest it could be a sign of a mania phase in the market, when investors chase speculative gains and disregard fundamentals.

Is the stock market in a bubble?

Analysts at Glenmede Investment Management have been tracking the unusual trend of unprofitable small-cap companies outperforming profitable ones since the pandemic.

In a 2020 paper, “Why Profitability Matters: Positive Versus Negative Earners,” they found that unprofitable companies tend to outperform only for short periods before eventually falling behind.

A follow-up study in 2023 reviewed 36 months of data and confirmed that pattern. The brief rallies in negative earners were followed by weaker performance, consistent with earlier signs of bubble-like behavior.

Glenmede also found that about 62% of new companies entering the Russell 2000 remain unprofitable, a level not seen since the dot-com era. Analysts attributed this to years of low interest rates that kept weaker firms afloat and encouraged speculative investing.

They expect that if interest rates stay higher, the trend should reverse, with profitable companies regaining their edge.

Meanwhile, analysts at Morningstar warn that the Russell 2000’s strong performance this year compared with the large-cap S&P 500 is unlikely to hold. They point to the “spotty or nonexistent track record of profitability” among many of the small-cap companies driving the gains as a key reason for caution.