Serious Money:Irving Fisher, the father of modern financial theory, declared on October 15th, 1929 that "stock prices have reached what looks like a permanently higher plateau". Two weeks later the stock market crashed and share prices subsequently dropped by more than 80 per cent before the market bottomed in 1932.
Today, market optimists argue that corporate profitability in the world's developed markets can be sustained at historically high levels.
Gavekal, an international research boutique, believes that the evolution of a new business model in the developed world has led to a "brave new world" in which "the rich nations get the profits" and "the poor nations get the jobs".
The research firm contends that the birth of the so-called platform business model, which focuses on knowledge while outsourcing production, heralds a structural rise in corporate profitability that is not as yet reflected in stock prices. Is it really different this time?
The American corporate sector has enjoyed four consecutive years of double-digit earnings growth, which have seen the pretax profit share of gross domestic profit (GDP) rise to a post-1945 high of more than 12 per cent. Meanwhile, the wage and salary share of GDP is in structural decline and languishes close to record lows.
Similar trends are observed in European countries including France, Germany and Italy. The optimists believe that these trends can be sustained due to the platform business model and the availability of low-cost manufacturing capacity in China and India. Platform companies increase profitability through their focus on marketing and design.
Unprofitable and volatile production is outsourced to emerging countries, which focus only on employment and not on profitability.
This enables platform companies to purchase all the goods they need at ever lower prices. The focus on high value-added activities results in higher profitability and lower volatility. However, to think that the higher returns will not attract competition is absurd and implies a breakdown in free markets.
The notion that emerging countries are focused only on employment is false. Indeed, a report on 100 of the leading companies in rapidly developing economies completed by the Boston Consulting Group reveals that these companies earned an operating margin of 20 per cent in 2004. This compares to 16 per cent in the US, 10 per cent in Japan, and 9 per cent in Germany. Furthermore, Chinese companies earn more than is commonly believed.
A study of more than 200,000 state-owned and private companies by the World Bank reveals that the profits of industrial companies have jumped by an average of 36 per cent a year since 1999. The average pretax return on equity earned by private companies more than doubled to 16 per cent, while the returns generated by state-owned firms increased from 2 to 13 per cent.
The idea that platform companies will sustain higher levels of profitability indefinitely ignores the fact that emerging companies will inevitably graduate up the value chain. New competitors typically attack an incumbent in the market segment it is least likely to defend.
Incumbents are least likely to defend business at the lowest level of technological innovation where profitability is meagre. However, as the new entrant becomes more efficient it will be attracted upstream, putting downward pressure on the incumbent's profitability.
Toyota is a perfect example of this process. It introduced simple and affordable cars into the American and European markets in the 1970s, but has since moved upstream to the high-margin luxury segment.
There is no doubt that the emerging economies such as China and India have had a considerable impact on labour markets. Real wages in the US have been almost stagnant for more than a decade, rising at an annual average rate of just 1 per cent, while the wage and salary share of GDP has dropped by almost four percentage points over the past five years. However, the corporate sector cannot garner an increasing share of GDP indefinitely without repercussions. Indeed, given that 27 separate anti-China trade rules have been introduced since the beginning of 2005, it it looks like the inevitable backlash is already under way.
The arguments for higher corporate profitability in the developed world are not only flawed, but are not supported by the data.
There is little evidence if any of a structural improvement in corporate profits over the past decade. Corporate profitability underwent a significant improvement in the 1980s and early-1990s in response to significant restructuring, but the recent rise to record levels is purely cyclical. Additionally, there is no evidence that profits are increasingly immune to the economic cycle.
Revenue growth is inextricably linked to nominal economic growth, while operating margins are largely a function of capacity utilisation in the manufacturing sector.
The hypothesis that corporate profitability has reached a permanently higher plateau will be severely tested in the year ahead as a sustained economic slowdown in the US will lead to pedestrian growth in earnings.
Historically, the corporate sector has struggled to generate earnings gains whenever nominal economic growth has been sustained at 4 or 5 per cent, while continued growth below four per cent has been accompanied by an earnings downturn. To quote Sir John Templeton: "'This time it's different' are the four most expensive words in the investing language."
Charle Fell is an independent consultant and lectures in finance and investment at UCD and the Institute of Bankers in Ireland
charliefell@sequoia1.ie
