It turns out that the bottom line isn’t the only line that matters. Much of the credit for the now 6-year-old bull market in U.S. stocks is justifiably given to cost-conscious company managers aggressively paring expenses to compensate for a lack of sales growth in the debt-besotted aftermath of the Great Recession.
And certainly, there’s nothing wrong with operational efficiency, especially during slack economic times. Over the long haul, though, few companies cut and slash their way to prosperity, or even to survival.
But there is a problem besides finding more and more customers — and thus generating solid revenue growth — in the age of deleveraging. Investors know it by the pithy phrase, “Elephants can’t dance.” It refers to the difficulty that companies (and economies) have in growing and adapting to a changing marketplace after they’ve achieved elephantine size. That’s especially true in older industries, i.e., those outside of health care and technology.
The global management consulting firm McKinsey & Company studied that issue over the two business cycles from 1984 to 2003. The results were sobering for companies struggling to grow their top lines faster than nominal GDP, or the growth rate of the U.S. economy without adjusting for inflation.
“Looking across the two economic cycles…revealed the critical role of top-line growth,” the report noted. “Large companies that trailed GDP for an entire business cycle were five times more likely to be acquired or otherwise go out of business than were faster growers. Eventually, companies that don’t increase their revenues run out of ways to drive earnings and shareholder returns.”
For a thorough review of corporate profitability as it relates to economic growth and sales, download the 16-page PDF published by Yardeni Research, Inc. The report notes that profits have been increasing significantly faster than the long-term rate of nominal GDP since about 2002 and that profit margins are extremely elevated relative to historical norms.
Sales and profits are two different roads, and they don’t necessarily lead to the same place. “The manager has his eye on the bottom line,” wrote the noted scholar and leadership guru Warren Bennis. “The leader has his eye on the horizon.”
Investors should keep their eyes on both.