TCS Daily


Poof to Profit Growth, Too?

By Kevin Hassett - August 20, 2001 12:00 AM

One of the most interesting data developments that has stayed below the radar is the disappearance of corporate profits. I do not mean the recent decline in corporate profits, something covered quite adeptly by the financial media. No, the truly interesting thing about corporate profits is that the growth we thought was healthy between 1997 and 2000 has been revised away by the Commerce Department's Bureau of Economic Analysis. We thought we were living in a profit boom. It turns out, at least if the current round of revisions has moved us closer to the truth, that we were not. There was essentially no growth in corporate profits in the late 1990s.

This is very big news for valuations. As Jim Glassman and I highlight in Dow 36,000, high business valuations depend very much on profit growth. Take away the growth, and current dividends need to compete with bond yields (which also don't grow). If all profit growth could be expected to stop forever, the Dow would have to drop by about 75 percent in order to make stock prices sensible.

How did the profit story get so bad so fast? Mechanically, here is what happened. The government collects profit data from public and private firms. For public firms, it is relatively easy to measure. Firms are required to make carefully audited accounting statements available, and they do so on a timely basis. Privately held firms, on the other hand, are not as tightly regulated. We generally only see their profits when they file tax returns, and those often take a long, long time to tabulate. Profits appear to have disappeared because small businesses and other privately held firms lost a great deal of money in the late 1990s, enough to offset healthy profit growth of the General Electrics of the world. The other factor worth noting is that the increasing liability associated with stock options appears to have been a bigger deal than we originally thought.

The downward revision of profits provides an interesting conceptual challenge to the New Economy models. We used to think that the information technology revolution increased both the productivity and profitability of firms. The data still suggest that productivity was higher, but profits are not cooperating with the story. What could have happened?

We will explore this question in detail in the next few Green Books. There are two main possibilities. First, it might be that productivity increased but profits did not. This could happen if the benefits of higher productivity are available to all businesses equally, and there are few barriers to entry. If true, then millions of small businessmen just invested their savings in business ideas that looked quite sensible, but turned out not to be because the business landscape was overcrowded.

The second possibility is that investment was very high during this time period, and that the spending on expansion lowered profits significantly. While profits were depressed at the time, the returns on those investments are about to start pouring in and even higher growth in profits is right around the corner. There is a variation of this second view that I am particularly interested in. Suppose that easy capital flooded into the corporate world, and many firms with appealing long-term prospects but iffy short-term profitability were created. As financial markets turned sour, this capital dried up, and many of the pioneer firms faced severe difficulties, even bankruptcy. If the investments made by these firms were sensible long-run investments, then healthy Fortune 500 firms can presumably purchase those assets today at fire-sale prices. Under this view, growth is on sale and it's very cheap.

This last possibility is clearly the most intriguing one for investors. If blue-chip firms are about to benefit from the investment boom of the late 1990s, now might be a very, very good time to buy. As we continue to stare at the economic precipice, it may be that this two-part question is the most important one of all: Did all that money get wasted in the late 1990s, or did we lay sound foundations, and now all we have to do is build the rest of the building?

Assuming that our blue-chip firms are run by sound men and women, there are a couple of scenarios that can shed light on which story is most reasonable. The crucial question is, what is happening to distressed assets? Are firms closing up and sending their ideas and machines to the scrap heap? If so, then the recession may be a long one. Or, are blue-chips sweeping in and filling their shopping bags? If so, then the road to high profit growth may have already been cleared.

The recent buying spree by the major telecommunications firms suggests that there may be some truth to the latter argument. Next time, we will dissect the aggregate data to try to construct a more complete picture.

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