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Why are company profits so high?

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An interesting note today from Andrew Smithers, the always stimulating independent economic strategist in London. He tackles the question: why are corporate profits as strong as they are at the moment – and can they be sustained? His analysis suggests that profits in the United States are three times the level they would be if they had reverted to average historic level. The wonder is that profits have widened dramatically over the past three years despite a sharp contraction in GDP – something that has rarely if ever happened before.

His conclusion is that the chief cuprit is not fading union power, nor the rise of China. It lies in the revolution in the way that corporate managements are now hired and rewarded. Short tenures and bonus-rich remuneration schemes linked to share price performance have resulted in a dramtic refocusing of management’s efforts away from long term investment towards much risker, short term profit maximisation. We all know this has been happening, but Smithers demonstrates it tellingly with a couple of powerful graphics.

Many managements, he points out, announce absurdly high returns of equity – typically two and a half three times the long run average. As a result it is no accident, he says, that corporate profits have become more volatile, that leverage has increased and that share buybacks have accelerated.  The worry of course is that this new focus is bound to lead to below average share price performance in the future.

Just as Eurozone leaders cannot go on kicking the can down the road with failed sovereign debt initiatives, so corporations cannot expect to sustain their businesses unless they are prepared to invest in new capacity.  “If we are lucky”, Smithers concludes, overdue changes in management remuneration will help to restore the balance towards investment, but “if we are unlucky, the distortions produced by the bonus culture will only be broken by another severe recession”. It is certainly not going to happen overnight.

Written by Jonathan Davis

December 9, 2011 at 5:26 PM

Posted in Andrew Smithers

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