Tuesday, September 01, 2009

Earnings vs. Revenues

Sometimes I have difficulty believing how simple and shallow business writers can be. Even at the Wall Street Journal.

Monday's edition carried a Money & Investing Section lead article seriously discussing whether the recent equity market rally, founded upon the belief of an economic recovery, can be sustained on profit increases without concomitant revenue growth.


There's no discussion here. The answer is a resounding, absolute "NO."

In my proprietary research on large-cap equities over several decades, I discovered that there is a large and clear-cut fault line between those companies which can grow revenues, and those which cannot.

The latter exist, and some can actually consistently outperform the S&P500 Index for several years at a time. In the past, Colgate's Ruben Mark did this for about a decade- the longest of any slow/no-growth company which I observed.

But, due to the lack of revenue growth, Colgate's margin of total return over the S&P was only a few percentage points per annum. Far, far below the average total return that the most consistent high revenue-growth companies achieved.

It's a stunningly simple theoretical argument which is borne out in empirical results.

While revenue growth allows all of the rest of the income statement, and, thus, balance sheet, to grow at a rapid clip, revenue stagnation or shrinkage does the reverse.

You can't cut 100% of operating expenses. Neither overhead, nor direct labor or materials. It's a long walk on a short pier.

Thus, without steady growth in consumer demand, low-/no-growth companies will quickly reach the end of what gains are feasible using only cost-cutting. After that, margins are pretty much purely a function of volume.

It's pretty simple. There's no need for a long article or hopeful conjecture.
No, the equity rally of the past few months will not survive another quarter of no revenue growth.

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