As the global economy put the short-lived post-bubble recession behind it in late 2002, corporate profits all over the world have exploded. Not predicted, not expected and largely without simple explanation, corporations of all types, in all countries, are taking home a greater share of world economic output than at any time in history. This change happened with astonishing swiftness, and has surely been a driving force in the global equity rally since late 2002. Profits normally rise in lock-step with economic output. This business cycle has seen profits rise at more than double the rate of economic expansion.
One prominent analyst described our time as the Golden Age of Profitability.
Ben Inker, of Grantham, Mayo, Van Otterloo in Boston, released an article last week that examined some of the conventional explanations for the profit explosion, and he found most of those explanations wanting. First, we have to realize that explaining the high profitability of the entire market is quite different from explaining the high profits of a single firm. When one firm’s profits rise, we can attribute it to rising market share, or the introduction of a new product or more efficient operations.
When looking at the entire collection of companies doing business, there is no increase in market share – it’s already 100 percent. New products coming on-line take sales away from other products; total product sales can only track along with total income growth. One company’s cost-cutting is another company’s lost sales. In total, the economic system balances out so that it does not grow faster than the total amount of global production. The global economy is a near-zero sum game, growing at just 3-5 percent per year.
So, how do total global corporate profits grow by double digits over such an extended period? An argument popularized among the investment intelligentsia recently is the notion of the “platform company.” This is the way of the future, they say. Successful companies – particularly in the developed West – will design and market products. They won’t make anything. Nike is an example, as are most high-tech and even toy companies. Most of these companies don’t own or operate manufacturing plants. They outsource manufacturing overseas, becoming less capital intensive and, hence, improving their return on this now-smaller capital base.
The platform company thesis argues that these companies will have higher profits and higher return on capital, since manufacturing is a low-return business. They will ship the low-return parts of the business off to China and India, and keep the high-return parts of the business for themselves. However, if this was the case, we’d see low return on capital in these outsource economies. As Ben Inker points out, we don’t. In fact, the return on capital has been higher in the emerging-market countries. If manufacturing is such a low-profit business, why are these countries’ corporations so profitable? Domestically, it has been the corporations with the most capital-intensive businesses that have improved profits the most. This starkly contrasts with the platform company argument.
Running down through a list of rather exotic explanations would take more space than we have today. Suffice to say that exotic explanations rarely prove accurate with time. As the economist and sociologist Vilfredo Pareto famously opined, the simplest explanation is usually the best. The simple explanation is that global economic output has been remarkably stable and strong. Each of the past three years has shown a higher and more stable global economic growth rate than any in the previous 20. But growth alone doesn’t mean high profits. In a balanced world, profits only grow as fast as the economy. Lately, profits have grown faster than the economy.
Profit growth depends on product demand. Product demand grows faster than the economy under one and only one set of conditions: Consumers spend more than they earn. This is the Pareto Principle at work in economic analysis; it’s simple and it explains a lot of things. Household liabilities – debt – have risen from 70 percent of annual income to 135 percent of annual income in the past 25 years. The personal savings rate has plummeted over the same period from 9 percent of annual income to minus 1 percent of annual income.
The question of whether recent record profitability can continue is answered in the paragraph above. If something can’t go on forever, it won’t. High profits are not explained by some new exotic economic paradigm that is permanent. These profit rates are fleeting, and profits will revert to the mean. Whether it happens this year or next, I don’t know. But like any committed value investor, I am placing my bets earlier rather than later.