As we have seen that the economy moves in a cyclical way and if the economy moves in a cycle then the industry will get affected by the cycle and due to that corporates also getting affected. The profitability of corporate earnings has been affected by the economic cycle. But such effects vary from company to company as per the inherent capability of the company.
Corporate profits rise and fall more compared to the GDP growth and we need to focus on factors that cause such cyclical trends.
And when GDP shows weakness
So corporate profits also getting affected by the economic cycle. We can argue that food, beverages, pharmaceuticals do not have any impact on the economic cycle. Yes, not high but during a recessionary environment, people tend to save more than what they earlier used to. People prefer to eat at home rather than to go out to a restaurant. People prefer to cut costs while experiencing a tough time.
Durable products majorly affected by the economic downturn because such goods can last longer and people can defer spending on such goods.
We should not have to directly consider that increases in the sales will similarly result in the increase in profits. This is because of the operating leverage. Cost mainly remains fixed and few costs increase with the sales.
In general, it’s higher for companies for whom a larger percentage of costs are fixed and lower for the ones whose costs are more variable. Operating leverage helps the companies when the economy is in good shape and sales rising. But when the economy and sales are in bad shape, profits fall more than sales.
Other than these, there are few other factors which can also affect the profitability of the companies such as management’s decisions regarding inventories, production levels, and capital investment; technological advancements (on the part of a company, its industry competitors); changes in regulation and taxation; and even developments exogenous to the industry or war, weather, etc.
The technological disruption led cycle such as streaming has killed the DVDs culture so that those businesses which does not welcome technological changes, they all get out of the business. Nokia & Kodak are also the biggest examples of got the worst hit on business.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
The economy also moves into the long term and short-term cycle as an industry, stock market and everything else moves which are explained further.
We know that the growing economy graph going upwards in the long term but it has short-term ups and downs.
Long term straight line is made up of small cyclical ups and downs of the economic cycle of recession and recovery, slowdown and prosperity. These are part of any economy.
Everyone gets agree with the above point but we also need to understand that long-term trends also having a cyclical move as same as the short term. Here we also need to put a focus.
We can see that the GDP of India has moved from US$ 0.04 trillion to US$ 2.72 trillion which shows long-term up moves but if we see shorter-term momentum of growth rate than it shows highly fluctuating with ups & downs.
When Population growing it will lead to more consumption and that encourages more production. For producing more, companies need more working hours and that will be converted into more GDP.
So, population growth remains key to the growth of an economy. If growth converts to degrowth then economy starting to shrink.
When the growth of population changes, it affects the GDP growth for a longer period of time. When a child gets born then it takes around 20-22 years for a child to become an employee. Also, migration from other countries replaces the birth rate of the country. Migration from other countries also enhances consumption and productivity which resulted in growth in GDP.
Another factor that affects GDP growth is productivity. As productive can be raised despite any growth in the population, then GDP also grows or getting slow with the slower or declining in productivity. We have seen the growth of productivity when human labour replaced by machines, new automobiles, electricity, and computer has introduced. But these all have taken decades of time to affect the GDP. So, for the year to year productivity remains steady. This is not a change that will come overnight and disrupt everything rather it will slowly create changes over a long period.
The aspiration to live a better life encourages people to work hard and produce more. Educational people contribute more to the economy but if people do not like to be educated then it will affect negatively the economy. Such negative effects need to be overcome by the migrated.
Technologies that introduce new businesses and replaced the older. Also, it affects employment.
Automation might have an effect on reducing employment, and thus income and consumption will also decline which again affects the GDP growth.
Globalization provides a chance to export to the other economies which enhances the GDP growth. But the impact negative to the economy which only relies on the import from the other economies.
We have seen that many factors take time to affect a long-term trend of GDP. Then why short-term fluctuations occur and why we need to focus on it?
There are factors that cause short-term fluctuations in GDP growth. We always need to focus on those factors to get an edge to our investment. The actual investment game is to getting superior returns than average. We should not focus on the correct forecast but should focus on the superior forecast.
Many of the economists extrapolate current trends and publish reports on it. Such information is available with every so that it does not add much value. Also, we do not get superior returns by doing the same what the majority is doing. It is easy to make any forecast on the excel sheet but it is very difficult to keep it near to reality.
Spending patterns of the individual affect the production of the companies and that has an impact on the GDP growth.
Similarly, companies feel that demand remains robust then they keep on producing more and more but what happens when demand does not come. These unsold goods added to the inventories and companies has to cut production until inventory does not come back at a normal level.
Recession in an automobile has impacted the inventories of OEMs
Few events also affect the performance of GDP such as war, changes in tax rate & trade barriers by government, cartels in the price of commodity, drought, flood, hurricane, and earthquake.
Superior forecast where we identify the deviation from the long-term trend and recent status of it. Identifying such deviation provides us with an edge. But identifying such is not an easy task and not all unconventional deviation also gets correct. We remember people for their correct unconventional prediction but they also have many failed predictions.
These all short-term factors affect GDP growth in a shorter time frame but that also helps us to get an edge into our investment. So that we require to have a keen understanding of all and focus on it for taking benefits.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
When rate cuts happen, people think that the economy is weak so that it required a rate cut. The reduced rate provides stimulus to the economy which resulted in the stronger GDP, higher corporate profits and higher stock prices. This is the first-level thinking.
Rather second-level thinker thinks that –
Why do rate cuts happen?
The economy is weak or weakening?
What damage can occur if rate cuts not happen?
How much worse it is?
Does this rate cut help to revive things?
Shouldn’t we need to take rate cut as a worrisome scenario?
A very nice example quoted by Mr. Marks that when we visit a doctor for our weak health and then he works on healing us through higher treatment, should not this worrisome for us?
First level thinker takes it as this treatment heal us and we will get all right soon
Whereas second-level thinker take it as –
how much worse it is that such high treatment is required? Or the situation is worsening highly?
Does it resolve the issue?
Is this treatment sufficient?
We need to think that the doctor has to bring a higher treatment that means simple treatment does not go to work for healing us. This means either issue is big enough or it is on the way to becoming bigger. So that when we have a bypass that means chest pain is not because of a gas problem but actually, we have a heart attack.
What can lead to growth at a lower interest rate?
Lower cost of borrowing – lower interest on EMI – more savings leads to more spending on the consumer front and that resulted in the GDP growth
Lower cost of borrowing – encourage businesses to make an investment – lower cost leads to more cash left with businesses to make further Capex – earning starts growing – more dividends or stock buyback enhance cash inflow to the investors – more spending – that increases GDP
Consumer spending increases – demand increases – encourage businesses to invest – more employment opportunities – more wages – increase consumers spending – GDP increases
The most important thing is that when interest rates go down then we reduce discount rates also. So that lower discount rates resulted in the higher assets prices. And lower rates encourage investors to take more risk to earn more return in the low return world.
Rate cuts provide hints for future rate cuts. And the above cycle keeps repeating.
There are many situations where lower rates are undesirable –
Low rates increase the inflation (some inflation is required for the growth but excessive can kill) – too much inflation increases cost of living – it makes hard for people to spend more money – lower rates reduces the return on the cash, money market investments, high-grade bonds so that people make an investment into the risky products to earn more return – people take more leverage to make an investment – this creates an assets bubble & some point of time it will burst.
Due to the lower interest rates, we provide lower discount rates to the assets which have increased the price of the assets and when the bubble burst interest rate increases which creates huge damage to the prices of the assets.
This is like painkillers which cure pain for now but harmful to health over a longer period if we continue with taking painkillers frequently for immediate relief then it can destroy our health in the future. So, we need to be careful while taking a painkiller for curing pain at the time.
We need to focus that whether growth is natural or artificial stimulating growth. If growth is not natural then central bank and government have to take measures to boost growth. Such kind of growth does not survive for long without stimulation.
As current slowdown is not only cured through rate cuts but the government need to bring further measures which can provide long-term domestic growth without any temporary stimulation. Temporary stimulation brings future demand in the current period or till the stimulation remains in the force. After that demand starts getting dry up. Such a stimulus can be more harmful and lead to huge damage to the economy at whole.
Inspired from Howard Marks memo – “On the other hand”
We all have some needs, some desire in life and we work for fulfilling those. But due to Inflation, our purchasing power get reduce which has always remained a serious question for all of us. We all working hard to beat inflation and enhance our purchasing power. We save, we invest money for our future life. The very popular story everywhere at the market prevailing is a common stock investment is a better tool to beat inflation compared to the bond investment. But is it true in all the situations? We know that every-time it is not true; many a time, good stocks do not give a good return compared to the bond. We need to focus on the valuation of the stock and yield available on the bond. It is very much possible that good stocks can be traded a valuation of the great stocks which can be harmful to us to beat the inflation by investing in it at such a valuation. And at such a valuation, investing into the bond becomes a better choice. Good business is not always a good investment.
Common stocks do not have an inheritance feature to always beat inflation. Yes, it is acceptable that stocks have delivered a good return compared to the bond in the past. But for the future, we need to look at the future of the growth of the economy, growth of the corporate earnings, etc.
If we see the growth of Japan then GDP grows at ~3% CAGR since the year 1981 and similarly their stock market also has given a return of 3% CAGR since the year 1981. Nikkei still is not able to break the higher level of the year 1989. So for growth of the investment return, underlying companies/economy also has to grow otherwise we are not able to earn by making an investment.
When inflation keeps on rising then companies need to bring more capital for growing sales (as the purchasing power of the company reduces) at similar peace. Such a scenario creates difficulties for businesses to survive and grow further. When companies need additional capital to grow similar sales level, then return on incremental capital will reduce, also companies cannot able to put capital to the new projects as old projects require additional capital. This also can enhance a debt level or the external funding to run a business and that can hamper the profitability.
One of the communication company
We can see that the capital employed of the company is growing at 16% CAGR and sales growing at 8% CAGR. This means for growing a similar business, the company need to make a twice of capital employed. So that company keeps on requiring external funding to grow the business. Here, we can see that company having a negative working capital cycle though the company needs to bring external funding to grow or maintain the business. There is much business which having such problems and those businesses require to have a huge capital to grow and to even maintain the business.
Hyperinflation stop consumer to buy more and more goods as their purchasing power starts getting reduced. During such time, businesses do not rise a price to overcome the impact of the rising cost of raw material and other utilities. So that hyperinflation can hamper the earning, growth of the companies and which having an adverse impact on the annual investment return during those time period.
Many people make an investment to the gold, real estate, old paintings, old currencies, etc. for beating inflation but such a scenario does not seem to be practical even. Real estate is a hot investment for getting protection against inflation. But if we missed with a location, the price needs to pay, etc then we also do not protect ourselves against inflation by investing in the real estate.
We should not focus on the one and only basket by seeing the huge return in the past. We should focus on the different basket for making an investment. As we have experience in the near past that due to good return from the equities, people have started making an investment into the equities and market got a huge liquidity flow which has bring the market to the record high level. Similarly in the past for the real estate market.
Our investment success does not count by how much % of return, we have made through investment but how much we left after adjusting inflation is considerable. That means if we have earned 20% return on our investment and inflation is 8% then we need to consider our return is 12% after adjusting inflation. And if our investment is not able to generate a positive return after adjusting for the inflation at a longer period of time then that is of no use for us.
Similar thing with the Indian economy, we also experienced a Current Account Deficit and we have to borrow money for supporting the economy. If the hyperinflationary situation starts prevailing to an economy then it will become difficult for the economy to grow further. We need to bring more fund to just maintain the existing state of living.
Disclosure – Companies mentioned in the article is just for an example & educational purpose. It is not a buy/sell/ hold recommendation.