Thursday, January 25, 2018
Thus, half a century ago, the doyen of management theory Peter Drucker wrote:
Profit serves three purposes. [First] It measures the net effectiveness and soundness of a business’s efforts. It is indeed the ultimate test of business performance.
[Second] It is the “risk premium” that covers the costs of staying in business – replacement, obsolescence, market risk, uncertainty … the task of a business is to provide adequately for these “costs of staying in business” by earning an adequate profit—which not enough businesses do.
Finally, profit insures the supply of future capital for innovation and expansion, either through ploughing back of profits or by attracting capital from outside investors.1
And Drucker continues:
None of these functions of profit has anything to do with economist’s maximization of profit. All the three are indeed “minimum” concepts—the minimum of profits needed for the survival and prosperity of the enterprise. A profitability objective therefore measures not the maximum profit the business can produce, but the minimum it must produce.
Adrian Wood, economist at Cambridge (England), offers a comparable description which lays more stress on business growth:
The chief objective of a typical firm in a capitalist economy is to cause its sales to grow. This entails the expansion of its productive capacity, which in turn requires investment in fixed assets and stocks [inventory]…in practice, ploughed-back profits are necessarily the main source of finance for investment. The central principle of the present theory, therefore, is that the amount of profits which the firm sets out to earn is determined by the amount of investment that it plans to undertake.2
Profits and growth
Thus the adequate level of profit for any business is based upon what it needs to survive, but depends also upon its desire to grow. We readily accept that the start-up enterprise wants to get bigger. On the other hand, with businesses that have already grown to a formidable size, we may well wonder whether they ought to continue to expand. Is it a good thing that McDonalds and Wal-Mart should persist in growing still further? Are they not too dominant already? Who approved of the relentless expansion of the Royal Bank of Scotland under the monstrously ambitious Fred Goodwin? Why should we encourage megalomania, or even tolerate it?
Here is one argument against the target of maximum profitability: as it grows, a business can generally widen its profit margins, because its expansion gives it bigger shares of its markets and thus greater pricing power.
Thus we have a self-feeding spiral: a bigger the business becomes, the greater are its possibilities of growing bigger still. This leads naturally to super-growth, even to gigantism with all its problems, as we see today in certain well-known cases. Would it not have been better if Hank Greenberg3 had been less hyper-profitable? In reality, the bigger a business becomes, the less it needs very high profitability.
Up to this point we have considered what level of profit is adequate to meet the needs and aspirations of a business. However, with the recent growth in the powers of large institutional shareholders, we have reached a situation where profit targets are fixed not by a firm’s own requirements, but rather by the demands of outside shareholders. With them, there is no objectively sufficient level. They just want as much as possible.
That flows logically from the rise of intense competition between investment managers. Such competition has existed ever since the first investment trusts were established in the nineteenth century. But in the past it was limited by lack of information. Portfolio valuations were done once or twice a year and announced a few weeks after the valuation date. Many life insurance offices carried out valuations only every three years, or even every five! Trusts did not necessarily publish detailed lists of their investments. In a word, there was not much transparency. Not much obsession with short-term performance either. Without the present plethora of data, there was no way to measure it.
Today, it is arguably all too easy to measure, and thus to compare, fund mangers’ performances. Not just year by year, but quarter by quarter, month by month … for it is now common to publish portfolio values almost every day. Hence the typical manager has become obsessed with maximising his or her short-term performance; for failure to do so will lead clients to switch to another, better-performing manager; which means, in our impatient age, almost immediately better-performing.
The performance of a portfolio is good if the shares in the portfolio rise. So fund managers, as large shareholders, push businesses to do everything to get the share price up. In other words, to grow net profits per share, as fast as possible. Immediate profits have to be swollen, not because this is good for the business, but because the big shareholders demand it. And they are driven to make these demands by the fierce competition between them.
The downside of greed
What are the pernicious consequences of the pursuit of maximum profits? We shall look at six.
First: disdain for the employees. Once upon a time it was believed, today it is sometimes said for the sake of public relations, that the best asset of a successful firm was its strong team. But the zealots of maximum profitability have convinced us that the staff are simply a cost that must be cut back as far as possible. Thus, instead of creating and keeping together good teams, too many businesses resort to frequent sackings, temporary employment, subcontracting, delocalisation…. This is not just a problem for those who lose their jobs. Those who remain are often overworked, overstressed, demoralised. And the business itself suffers from the deterioration in the quality of its staff.
Second: neglect of long-term investment. The cult of immediate profit per share harms a business’s development for the future. You may reply that, if a business is making maximum profits, surely it has plenty of money available for development? In theory, you are right. But firms have got into the habit of using business profits to pamper the people at the top and to buy back some of the company’s shares. This reduces the number of shares in the market. With fewer shares, obviously there is more profit per share. That is the greedy investor’s dream.
Third: excessive risk-taking, as we have observed recently in far too many banks. One takes big risks in the hope of making big profits. This game can pay off … or it can fail disastrously.
Fourth: as we have noted above, the search for maximum profits tends to lead to the growth of oversized business giants.
The search for remedies
How can we discourage, if we cannot prohibit, the frantic pursuit of excessive profits? To lay down by law limits on the profitability of businesses would be totally impracticable. The best solution would be a radical change in prevailing attitudes, a general repudiation of the Gekko philosophy, greed is good. We cannot legislate for that either, but we can encourage it.
1. Peter Drucker, The Practice of Management (Harper & Bros., New York, 1954), chap. 7.
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