February 25, 2008

The brave new world of finance-11: The changing emphasis of business

(For previous posts in this series, see here.)

The problem with the modern business world, as I see it, is that it is no longer enough that a company be successful in the traditional sense of steadily producing revenues in excess of expenditures. That model of a successful business is considered hopeless naïve these days. What investors want is not steady profits but a steadily increasing rate of return on investments and this is leading to chronic instability.

Let me give an example. Suppose I start a business that returns a 20% profit on my investment. That is a nice return, allowing me to provide good salary and benefits to employees, reinvest something in the company to improve the product, expand and improve the product, and so on. You would think that if I could continue to produce roughly 20% profits every year, I would be having a good company. After all, I am employing people, producing useful things, and making a reasonable amount of money. And as long as the company is privately owned by me, that might be true.

But things are very different if I take my company public and sell stock to investors. You would think that the stock market would also recognize and reward such a solid, stable, company by increasing the value of its stock. You would be wrong. Although my rate of profit might enable me to pay fairly good dividends to the stockholders, that is not enough to raise the price of the stock. If the CEO of such a company says that he expects the profits next year to be the same as the current year, the company stock will tank. What the stock market wants to hear is that you will increase the profit margin each year. So 20% profit in one year means that you have to produce (say) 25% the next year, and 30% the next year, and so on. And the stockholders want to see you take steps now to make that happen in the future. This immediately sets up an unstable situation. One simply cannot sustain such a runaway rate of growth without creating a negative impact in other areas. This is why we see companies that are making huge profits still cutting back on their work forces and squeezing salary and benefit concessions from their employees in their desire to drive up profit margins.

There are some businesses that could be very stable and profitable, but become unstable under the peculiar and voracious demand to raise profit margins. Newspapers are a good example. In most American cities these days, one daily newspaper has a monopoly. This makes for a stable market and a potentially stable, or even slowly rising subscription base, which is what is used to set advertising rates. It is true that the rise of the internet and things like Craigslist has eaten into much of their once hugely profitable classified advertising market. Old timers like me can remember the days when the Sunday classified section was of a monstrous size, often equal to the rest of the paper combined. Those days are long gone, perhaps thankfully given the waste of newsprint, but newspapers have survived that loss and most daily newspapers make healthy profits of around 20%. In fact, the average profit margin of newspapers is greater than the average profit margin of businesses as a whole. If they were allowed to remain that way, they could function quite nicely, putting out a good product. But that can only happen with privately owned newspaper companies. With public companies, the demand by stockholders to raise the rate of return is slowly destroying them. They cannot keep raising advertising rates or subscription prices or subscriptions by sufficiently large amounts to meet the demand. They are thus forced to cut costs and this is usually done by targeting the biggest expense and that is reporters, particularly investigative reporters.

One person who used to work for The Philadelphia Inquirer writes: "When I worked there as a staff writer, in 2000-01, I watched in disbelief as the paper let many of its best people go, to appease the cost-conscious Wall Street investors. Space for local coverage kept disappearing, and the suburban newsroom where I worked took on a graveyard-like atmosphere, with three or four abandoned desks for every one that was occupied."

Thus newspapers end up gutting the main reason for their existence. So while profits may rise in the short run, the quality of the newspapers tends to go down in the long run, leading to an eventual decline in readership, leading to loss of revenue, and thus calls for more cuts. We see this happening right now with the Los Angeles Times, where the editor abruptly resigned because he was asked by the publisher to slash the size of the news staff in order to cut costs. Previous editors quit for the same reason.

Another industry that is in decline, not because of any intrinsic problems but because of the demand for rising rates of profits, is the book publishing industry. This industry used to contain a variety of niche publishers who would put out their own lists of quality fiction and non-fiction and manage to make a small but respectable profit, even while taking chances with new and untried authors. But the takeover of these houses by the big public conglomerates has resulted in the same kinds of pressure to increase the rate of return. But the book market is not very elastic. There is simply a limit to the number of books that a person can read in any given year and the number of readers is generally stable. A phenomenon like Harry Potter may occasionally expand the overall readership size, drawing in new book buyers, but those things are rare. So how does one raise revenues dramatically? By abandoning niche markets, forsaking quality literature or risky new writers, and instead trying to identify the next blockbuster, the next Da Vinci Code. But again, this leads in the long run to deterioration in the overall quality and diversity of the books that are published.

The February 2008 issue of Harper's Magazine has a nice article Staying awake: Notes on the alleged decline of reading by novelist Ursula K. Le Guin where she challenges the assumption that the reason that the book publishing industry is suffering is because people are poorer readers now, and argues that the unreasonable profit demands of big publishing companies is what is destroying the book publishing industry.

Next: The consequences of the primacy of stockholders

POST SCRIPT: Some religious people never learn

The state of Florida has revised its science standards and for the first time, has included the word 'evolution' in it. (Welcome to the 19th century, Florida!) But of course some religious people were upset, as they always get the heebie-jeebies when the word evolution rears its head. So to mollify them, the wording was changed to refer to the 'scientific theory of evolution'.

The irony in this story is that the religious people thought that this was somehow weakening evolution, when it is in fact strengthening it. To call something a scientific theory is to give it high praise. How clueless can they get?


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