Wednesday, 29 April 2020

Resource Allocation and Utilisation: Corporate Profitability meets Economic Objectives

One of the key issues that the field of economics addresses is the optimum allocation and utilization of resources. How do we choose between competing objectives when our resources are limited ? How do we transform scarce resources in to productive outputs and at what cost? In spite of all the advancements of mankind in most fields, these fundamental questions of economics still persist.

In a free market economy, the burden of the choice between competing projects/undertakings falls on individuals and businesses. At least once in a while, it is necessary to assess if our collective decision making is navigating us in the right direction. So how do we know if our micro economic decision making enhances broader welfare ?

One of the key indicators of efficiency in resource allocation and utilization is corporate profitability. In this context, take a look at these graphs on the basis of data provided by Prof. Damodaran. (Reference and Acknowledgements: Prof. Damodaran's blog post)

On a global scale, 52.05% of all companies have generated returns (measured in terms of return on invested capital) that are lower than their cost of capital in the year 2019. 15.32% of all companies generated returns that are within 2% of their cost of capital and only 32.63% of all companies were able to generate good returns in excess of their cost of capital. If you are crying foul that this is only one year's data (2019),the last decade does not present a great picture either. Growth does not have any value when the cost of capital exceeds return on capital.

Purists would argue that this definition of  returns and costs is very narrow as it does not include environmental costs, tail risk behavior and other externalities. If we include these costs as well then the picture may depreciate further.

Rather than fretting over methodology or data, every company needs to reassess its profits and costs. At least, in the longer run it should be possible to improve the return performance of existing businesses, exit non-profitable businesses and move into more productive sectors.

Activist investors have a role to play here. By taking positions on corporate boards they can steer the management towards the right path.

All hail Lord Keynes, government intervention is required not just during recessionary periods but almost always to nudge private investments in the right direction. Governments cannot limit themselves to infrastructure investments. Productive investments in different sectors is as important as divestment of unproductive businesses. Healthy competition between public and private sector is the need of the hour.

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