What’s the profit cycle? How does a company’s debt affect its true profits?
Howard Marks says that the economic cycle is closely related to another foundational cycle: the profit cycle. The profit cycle undergoes sharp swings as profits regularly increase far more than 5% or decrease far more than 2%.
Continue reading to learn why the profit cycle experiences these sharp swings.
The Profit Cycle
Marks points out that the profit cycle’s sharp swings happen for two reasons. First, many industries’ sales (which correlate with their profits) are extremely sensitive to shifts in the economic cycle. For example, the tourism industry sees exponential sales increases in years of economic prosperity and exponential decreases whenever there’s a recession. For this reason, their profits are much more volatile than the economy at large—if the GDP dropped 1%, for example, profits in the tourism industry might drop 10%.
(Shortform note: While it’s true that some industries’ profits are especially sensitive to economic turmoil, experts point out that other industries are largely resistant to economic downturns. For example, grocery retailers enjoy similar profits even amidst economic turmoil, as groceries are a necessity regardless of the state of the economy. Surprisingly, the same is true of the cosmetics industry, suggesting that people might forgo larger purchases for little pleasures (like high-quality makeup) when the economy struggles.)
Second, Marks explains that companies that are highly leveraged—that is, financed heavily with debt—have profits that are much more sensitive to changing sales revenue because they have to make interest payments that cut into their profits. For example, imagine a start-up company that’s financed with $50,000 of debt, requiring $5,000 annual interest payments, and $50,000 of equity. If this company’s operating profits (that is, its profits from sales before deducting interest payments) dropped from $15,000 to $7,500, then its true profits would drop from $10,000 to $2,500 after deducting interest payments. In other words, a 50% drop in operating profits from sales would correspond to a 75% drop in true profits.
(Shortform note: According to experts, companies are most likely to be highly leveraged if they’re in industries that require significant capital, such as manufacturing or infrastructure, or companies trying to aggressively stimulate growth. For example, the S&P 500’s most leveraged company in 2020 was Colgate-Palmolive, as they had recently pursued several expensive acquisitions to grow larger.)
