- Capital Gains
- Where Do Abnormal Profits Come From?
Where Do Abnormal Profits Come From?
In a Simple Enough Economic Model, They Don’t Really Exist
One reason people major in economics is because it seems to be most related to making lots of money, which makes it a sort of vocational degree for white-collar professionals. For anyone who chooses economics on this basis, they'll get a disconcerting experience in Microeconomics 101 when they learn that, in the initial stylized model, profits are assumed to be zero. It's like going to divinity school and hearing your professor dismiss all the texts you'll be studying as a collection of unusually well-recorded Bronze Age fables. Surely there's more to it than that!
There is, of course, but you have to start somewhere—understanding a religious text means understanding the context in which it was written, and understanding the economy means starting with a theory simple enough not to admit the complication that some people make money, some of them lose it, and nobody can perfectly predict who will end up in which category.
The microeconomics 101 model of profits starts its counterintuitive conclusions with some intuitive-in-retrospect accounting: yes, companies earn accounting profits, but they also have a cost of capital. If a company can sell equity at 10x earnings and invest those proceeds, with or without debt, for an annualized 10% return on equity, then growth is a breakeven proposition: they've converted money that needs to earn 10% into an asset that earns 10%. That 10% is the hurdle rate.
The existence of that hurdle rate implies that there are other investments out there that offer similar risk-adjusted returns, since otherwise the investor would just hold cash. And that sketches out a simple equilibrium: when there are abundant opportunities, companies are willing to raise money even at a high cost of capital. When investment opportunities are scarce, even very high share prices and very low rates on debt aren't enough to coax them into more investment.1
A more fleshed-out version of that equilibrium does embrace some differences in profits on a per-company basis, without accepting them on an aggregate basis. Consider two railroad networks: one of which connects a dense and growing cluster of manufacturers and of population centers that demand the goods those manufacturers make, and another of which is spread over a sparsely-populated area with little economic activity. Perhaps the first company gets a return on equity of, say, 22%, and the second earns something more like 2%. In that scenario, the aggregate return on equity is 10%, assuming they have the same asset base.
What maintains this equilibrium? We'll smuggle in real-world details that are beyond the scope of the argument to make this case, but: in this scenario, the high-ROE railroad probably can't expand much; getting environmental permits for a new railroad would be a nightmare, and the US's total railroad mileage has dropped 63% from its peak. So the lucky railroad might be able to afford better railway vehicles, or more investments in adjacent logistics businesses. But if it has a quasi-monopoly, why bother? The incremental return won't be the same 22% the company is enjoying, and may not even hit their sector’s 10% hurdle rate.
So, what keeps the other railroad company alive? While 2% is a low return on equity, it's still higher than zero, and a company whose main assets are rights-of-way and metal structures scattered over a large area is a company that won't produce much if it liquidates. So capital doesn't get reallocated in this scenario, except in the very indirect sense that the low-return railroad probably dividends out everything it earns. On the other hand, the high-return railroad has more of an incentive to pay up for maintenance, but it too will ram into equilibrium as soon as the returns from maintenance don't hit the required rate (and there's no way to expand).
There are other sources of high returns. For example, capital won't equilibrate if one business has regulatory favor and another one doesn't. Ozempic is not that expensive to manufacture, but there are a limited number of approved GLP-1 agonists, and getting a new one approved is expensive.
And we can widen that lens even further: high-risk industries will tend to have high profits on average, because the real capital cost for the industry is the cost of investing in enough failures to have a shot at backing one of the winners. So when we look at the returns for industries like biotech, we're looking at a cohort of successful companies, and generally omitting the failures that cropped up along the way.
The railroad and biotech examples illustrate another case where companies can earn superior returns on equity: regulatory barriers can prevent competitive capital from flowing into an industry. Getting these right is a tricky balance: ratings agencies, for example, benefit from Nationally Recognized Statistical Rating Organization status, meaning that their ratings can be used by investors who themselves are required by regulation to invest in highly-rated bonds. If anyone could slap a legally-valid AAA rating on whatever they wanted, regulations that use ratings would be pointless. On the other hand, some of these NRSROs have taken advantage of their status, both by charging high prices and by tolerated periodic slippage in ratings quality. For some regulated industries, like utilities, their government-protected monopoly status is tied to specific return on equity levels, but that's messier in cases where the company's assets are intangible.
In all of these cases, fitting this to a simplified model is a matter of a handful of tweaks, or a careful review of the assumptions underlying the model. But there are exceptions to that, too. There are famously successful companies that don't have any government-granted monopoly, but that do have network effects—Google's data advantage in search grows every day, meaning that they can provide better search results, better targeted ads, and higher payouts to partners who make Google a default. Microsoft (disclosure: long) benefits from the fact that its document formats are de facto standards, and the risk of a mistake is too high—sure, you could use OpenOffice instead, but what's the cost of one complex Excel formula that gets evaluated slightly differently in the open-source implementation, or one red-lined item in a contract that accidentally gets treated as an unadorned piece of the final text? Even if that risk is low, the people choosing between office software suites are not well-equipped to evaluate it, and, as a result, Microsoft collects a nice recurring royalty from the economic activity of lawyers, bankers, accountants, etc.
These businesses don't line up with simplistic economic models. They're rare, which helps—the median business is closer to something like a barber shop, single-location restaurant, independent trucker, etc., i.e. unlikely to earn super-normal returns without attracting competition. But increasing efficiency in labor and capital markets means that the exceptions to this norm can get quite big, and even if they're a small share of the economy, they touch a larger share of economic activity (how much total commerce is directly or indirectly mediated by the biggest online ad platforms? Amazon (disclosure: long) collected ad revenue in 2021 that amounted to 8% of the estimated value of third-party transactions on its site. And those ads will have a higher take rate compared to revenue, because they're generally shown to existing Amazon customers who have searched for a specific product, i.e. the ad viewer has a very high propensity to convert. Apply a similar benchmark to Google and you can estimate that Google drives around $3.7 trillion in total economic activity.2
Yet another category of businesses that don't fit the models are the companies run by good capital allocators. Conglomerates like Berkshire Hathaway, Danaher, and Transdigm are not necessarily more than the sum of their parts, but they've chosen which parts to buy (and how much to pay) opportunistically. If the market occasionally thinks that a business that can earn 12% on equity is really only capable of doing 8%, and an investor takes advantage of this, they'll end up with a portfolio that compounds fast, both because of the long-term benefit of investing at high rates of return and the one-off benefit of getting a good initial price.
Fortunately for the simplistic models, great businesses and great capital allocators are, in different senses, mortal. But we all live in the short run, where models are imperfect and a lot of their value comes from examining their premises to understand the exceptions. It is true that if you assume perfect competition, interchangeable products, easy entry and exit from all businesses, perfect information, a desire to maximize profits, and zero externalities, the absence of economic profits ends up being an obvious conclusion from the model. All of those assumptions are approximately true, none of them are precisely true, and it's in the gap between "almost" and "always" that economic profits live.
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Read More in The Diff
The Diff spends a lot of time looking at companies with unusual profits from each of these sources. A sampling:
Airlines can be modeled in many different ways, with each one providing a different lens for understanding whether or not the industry ought to be a profitable one.
You can think of growth companies, i.e. companies that earn a decent return on equity and can continue to reinvest it, as existing because they’ve eliminated all the reasons companies ultimately don’t grow ($).
There are surprises in store when a growth industry gets regulated ($).
A company like Birkenstock ($) shows that investing in a brand is a good way to achieve high growth, but only by converting that brand equity into pricing power.
1. We saw such a world in the 2010s, when plenty of companies returned all of their cash flow to investors, mostly in the form of buybacks, because they simply didn't see any opportunities to deploy that money in their business at acceptable rates of return.
2. This is a very rough estimate. A big Google category is financial services, where margins can be higher because the products are intangible. Ads for class-action lawsuits, software, etc. will also have a higher take rate. Offsetting this is the fact that for physical goods or travel, Google's take rate is slightly lower than optimal, because an ad for, say, Booking.com will have a lower conversion rate if some fraction of users are put off by the need to create a Booking.com account. As it gets easier to log in with Google credentials on multiple sites, and to use payment information stored in the browser, this monetization gap will decline.
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