This is the continuation of a 10 part blog series entitled, “10 MACRO HEADWINDS IN THE FACE OF INVESTORS”.
I want you to imagine a pizza pie on top of a pizza pan (fresh out of the oven!) Now imagine cutting that pizza pie into a bunch of smaller pieces. Now remove all of the pieces from the pan except for one. Let’s call that single remaining piece of pizza, “corporate profits” and let’s call the entire pizza pie “GDP” (gross domestic profit). Gross domestic profit (which represents economic activity) is comprised of a lot of pieces such as personal consumption, investment, savings, corporate profits, etc.
Corporate profits are simply a component of GDP (a single piece of pizza from the entire pizza pie). Over the long term, corporate profits are usually around 5% of GDP (1/20th the entire pizza). We can now imagine cutting up the pizza pie into 20 pieces, eliminating 19 of them and that one remaining piece is “corporate profits.”
Over the past few years, corporate profits as a % of GDP have grown tremendously relative to the whole pizza. They have moved up from 5% of the total to the low teens (around 13%). We should be asking, “Why is this?” (I know you are losing sleep over this issue just like me. Staying up late, tossing and turning and wondering how this is going to impact your life.)
And if we step back for a moment and ask, “How did corporate profits/productivity increase so much in so few years?” Is everybody on Red Bull at work?
Corporations have learned to do more with less. More work output, less labor input. You, you and you get back to work, the rest of you, “You’re FIRED! Get your stuff and go home. Thanks for playing.” Companies also aren’t investing in new machinery, new factories, new upgrades, and new expansion. Rather, they are saving their cash and squeezing every ounce of profits out of the organization. Research and development is also carefully watched. This is not the time for companies to feel like taking risk on creating new things that may not pan out in an uncertain future. Lean and mean.
Let’s head back to the pizza pie and the slice for corporate profits. Now all of a sudden the piece of pizza which is normally 1/20th of the pizza is now 1/8th of the pizza. But if we think about the obvious, this growth cannot last or expand forever. A piece of the pizza can’t become bigger than the pizza itself. There are natural constraints to the growth. 70% of the economy is consumer driven. If less people are working, or wages are slashed, or people are cash strapped, how will they have money to buy the crap made by corporations? So things are ultimately inter-related.
The global economy should always be growing (the goal of all economies is growth). The growth is like growing from a small pizza to a medium pizza to a large pizza. As that pizza grows, the slice for corporate profits should grow in proportion. But now the pizza pie is no longer growing. A shrinking pizza is called a recession.
If GDP stops growing, then we should expect corporate profits to stop growing (as corporate profits are a component of the entire pizza pie). Stock prices reflect the expected future growth of corporate profits. The faster the growth in corporate profits, the faster we should expect stock prices to rise. In similar sense, should corporate profits halt (or go in reverse) so should stock prices as the value of the companies are now diminished due to shrinking profits. Who wants to own a business with shrinking profits? As profits diminish, investors should only be willing to pay less for that business, not more.
And thus we should now be able to follow the bouncing ball and connect the dots. If GDP slows down or halts, we should expect corporate profits to slow down or halt as well. Further, corporate profits as a percent of GDP are already inflated and far above historical averages. What will happen to corporate profits if they revert to the mean and move back towards their long term average of 5% of GDP? (Uhmm – BAD…) And if corporate profits halt or recede, then what should happen to stock prices? That’s right, stock prices should halt or recede as stock prices are a reflection of future profit expectations.
GDP impacts corporate profits. Corporate profits impact stock prices.
If GDP growth slows down to low single digits (or less in certain countries and economies), why should an investor expect stock prices to rise much above and beyond that GDP growth rate?
As an investor, our goal is to always understand our potential risk versus the potential return. Stock prices tend to front run actual economic data. And sometimes the economy is doing great but stock prices fall and sometimes the economy is doing poorly but stock prices rise. It’s a fun game, I know. But the wise investor is always attempting to understand what they have to gain versus what they have to lose. If prices get cheap enough, then an investor has less to lose. They have built in a margin of safety.
Comments