Firm Profitability - Does it really matter for shareholder return or ROE (return on equity)?
Firm Profitability - Does it really matter for shareholder return or ROE (return on equity)? Does this question sound oxymoron or antithetic? Not really. On the contrary, evidence has surfaced that Returns on equity - the shareholders equity in balance sheet - is not really directly tied to firm's profits, assets or net income. And a higher stock gains can be achieved, when stock investors are smarter and faster to execute their stock-buy & sell at the right time and speed. Notwithstanding what the conventional wisdom is, the disconnect between profitability and long-term ROE is becoming the hard truth in a modern stock market, while smart investors can achieve better return through active trading.
Then, where does the gain come from for an investor? Instead of arriving at the value of a stock based on actual or potential profits, now it appears more and more the stock prices are arrived purely on "speculative-ability"...there lies the jackpot; and this is really not 'profit' 'per se', but a bonanza for creating the capacity for a stock to make marginal gains on a hour-by-hour or day-by-day basis rather than waiting for dividends and stock-value appreciation of the assets. In other words, there is nothing like pay back period or long-term ROE in stock investments anymore..It is only how much one would gain marginally in pay back minutes or days to maximize the wealth. Actually, it appears continual short term trading would yield more returns than keeping the stock to realize the rents from the stock investments. Before the recent stock market crash in China in 2015, it was reported that short-term traders made 7 times more returns than long-term investors.
Then, from the management point of view, the profit advantage for shareholders does not emerge out of management efficiency or productivity or operating margins or profitability, rather arise out of the capacity of the ticker to yield marginal jumps on any given time scale. In this light, What will be the most valued competence of the firm or management to fetch higher returns to shareholders.. especially for those investors who are ever-ready to roll the dice on a short-term basis rather than willing to wait for the long-term results? that will be, the ability to sustain marginality or taking advantage of volatility. A deeper analysis reveals that markets are now displaying a pattern of volatility appeared to be a systemic pattern in marginal ebbs and flows of stock trades and their respective prices.
These observations substantiate the fact that by and large stock prices are not arrived on the basis of the random aggregation of judicious asset pricing by a large body of shareholders (known as random walk model). This not only discredits the market efficiency (MEH-Market Efficiency Hypothesis) argument, but also reinforces the notion of systemic variance in the movement of stock prices - which may relate to both marginality and volatility. Now, the corporate governance is naturally inclined toward seeking the triggering levers rather than seeking efficiency, innovation, profitability or real growth to fetch higher returns to shareholders.
That is, by promoting investment cues, how to take advantage of marginal ebbs and flows or volatile swings and mainly catering to the ever fleeting investors. But the long-term investors would not see much gain unless the stock delivers high dividends on a continual basis. The widening Price-Earning ratio of S&P 500 firms, which doubled from the 75 year average of 17 to 40+ in the last ten years.
Several factors can be said to provide the inducements for this trend...
1) Continually increasing investment flows (nearly 3 trillion dollar worth of new investment flows each year; and most of these are retirement savings of the middle class working population channeled through institutional investors). These money have nowhere-else to go ending in stocks inflating the stock prices and price-earning ratio.
2) Reduced number of investment choices; that is more and more investment flows to fewer and fewer firms. Due to consolidation, buyouts, mergers, failures, the number of public companies have declined from 8000+ in 1990s to 5000+ in 2015.
3) Large firms not able to generate and distribute the long-term returns in steady and stable ways.
4) No incentive for keeping the investment in the same firm for long-term.
5) Reduced connectivity between firms and original stock or equity-holders.
6) Imperfect market conditions: Information asymmetry, overload, and biases...
7) More importantly, the declining associations between firm size, asset size, and market capitalization for Fortune 1000 companies and more so for Fortune 100 companies (due to global competition, diminishing returns to scale and share value, unsustainable size and structure). Given that substantial amount of investments are tied to the Fortune 1000 firms, (about $45 Trillion) multi-trillion dollar investments at high risk.
Will this short-term buy-&-sell trend further increase the volatility? Should the long-term investors like retirement stocks and mutual funds also play the short-term trading game to maximize their returns? If long-term institutional investors too join short-term trading, won't it further exacerbate the volatility? Can there be any incentives designed (by regulations, corporations, dividends policy, tax policy) to reduce the volatility? Can the erosion and loss of value due to volatility be eliminated or reduced by designing some kind of systemic buy or sell schema (some thing like LIFO and FILO - Last in first out or first in last out in a gradual manner)? Often, we see regulators trying to shutdown the market to stop the melt-down. Rather there should be systemic methods designed to avoid the quick erosion of value - such as the mortgage crisis that eroded trillions of dollars of value triggering a global economic melt-down. These are the questions for the government, stock exchange regulators, and institutional investors - who carry the hard earned savings of the millions of working people.
Caveat: Of course, profitability matters. The objective of the article is to highlight the increasing disconnect between stock market reaction and how much profits a firm actually makes. When a firm can just meet the bare minimum profits and show however high growth, it is highly likely that stock markets will respond to it more favorably. On the other hand, when a firm keep accumulating assets without meeting the bottom-line, then it carries the risk of going down like Tyco along with then CEO Dennis Kozlowski. (https://en.wikipedia.org/wiki/Tyco_International).
However, whether in the presence or absence of anti-trust laws, right sizing / structuring of firm's assets is quite significant for achieving high growth. In this light, firms need to proactively slice their assets and operate like a school of fish rather than a large shark. Case studies on Nucor, HP, Google, and Samuel Adams are available in the website: www.schooloffishstrategy.com)