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Why investors need the sizzle and the steak

Activity is the sizzle, profits are the steak

Charles Farrell //June 1, 2016//

Why investors need the sizzle and the steak

Activity is the sizzle, profits are the steak

Charles Farrell //June 1, 2016//

Over the last nine months, corporate profits for S&P 500 companies have declined, yet the economy, as measured by GDP, has continued to grow. In general, this is not a pattern we see in the financial markets. If corporate profits are down for a sustained period, we are usually in a shrinking or recessionary economy.

But today, the financial markets are in a profits recession, and the economy is in a growth mode (albeit slow). So which of these things should investors pay more attention to? Profits or GDP?

If you are an investor, you pay attention to profits. Regardless of the GDP figures, if profits are shrinking, it's not good news for investors, whose success is based on the profits generated by the companies they own. If they don't generate profits, then the value of the business is eventually going to decline.

Gross Domestic Product only measures output in the economy, it doesn't measure whether what we are making is profitable. We can't recall who said this, but we heard an investment manager not too long ago describing how you can create GDP without regard for profits. He basically said, you build a bridge, and then you tear it down; you build it again, and then you tear it down; you build it again, and then you tear it down. With that simple example, he got across the point that GDP activity doesn't necessarily have anything to do with profits. 

The bottom line is, activity is the sizzle and profits are the steak. As investors, how does this impact our decisions about the businesses in which we invest? When we look at companies, our focus is on profits and the conversion of those profits into real cash flow to investors via dividend payments. We don't simply look at things like sales or revenue increases. Those numbers can be more akin to the headline GDP figure. A company might be selling more, but not necessarily making more profits from those sales. You have to do both.

For example, over the last year we have seen a large number of mergers in the corporate world. While sometimes mergers are helpful, the vast historical evidence of merger outcomes indicates most of the time they do not lead to enhanced profits for investors. They may boost the size of the company and the CEO's pay, but not what ultimately ends up in the pockets of investors. We have removed a few companies from our portfolio that undertook large mergers within the last year. To us, they appeared to be more of a revenue grab and not necessarily an enhancement of profits.

In the energy and commodity areas, we are seeing tons of activity as the world produces more oil and gas than ever, but not necessarily more profits, so we have made some decisions to trim risks in those sectors as well.

We also will avoid broad stock market investments in countries based solely on GDP growth as an investment theme, because again that doesn't mean the growth is profitable. These economies are often creating economic activity by borrowing heavily, which can create the illusion of sustainable economic growth.

In a different way, many new tech companies also exhibit this revenue versus profits dilemma. They can crank up revenue and activity quickly but not necessarily profits. Think about this simple example. Let's say we wanted to create a new tech-focused chain of hamburger restaurants where the food was free but we sold edible advertisements printed on the buns and you ordered via an app (which also swamped you with ads).

We could probably drive lots of burger sales as people flocked to our free "sammies" but maybe not much in profits. Yet as long as we can keep investors focused on the sizzle of rising sales and not the steak of our profits, we can keep the game going until we at least cash out. As you might imagine, we avoid companies with these sort of growth plans. The prospect for profits is just too speculative.

The financial markets today are more challenging than they have been in some time. We have many red herring indicators that are confusing to all of us as investors, including: growing GDP and declining profits, negative interest rates, deflationary pressures, full employment yet little wage growth – the list goes on.

Reports on GDP growth, employment figures, interest rates and inflation, are all helpful in providing an understanding of what's going on in the world, but they aren't what define the value of your investments. Value is defined by the profits and cash flow delivered to you as an investor.

This activity versus profits conundrum in the economy has caused us to reduce somewhat the number of companies we own in our model portfolio. We would rather own fewer businesses with better profits than more businesses with greater activity.