Investing in the stock market makes sense, part 3

This is the third part of the “Investing in the Stock Market Makes Sense” series.

How is it that publicly traded businesses can regularly grow their earnings at a pace significantly higher than that of GDP? After all, isn’t GDP the aggregate measure of all economic growth (i.e. profits) in the economy? And don’t the publicly traded firms represent a disproportionate amount of the economy’s growth?

Publicly traded businesses, by definition, are those that have robust growth prospects. In fact, the only logical reason to become a publicly traded firm is to have easy access to inexpensive capital (i.e. issuing equity). As a prospective shareholder it only makes sense to invest in those companies whose total return will exceed not only the growth in GDP, but also the return on the same company’s bonds. If a company cannot do this consistently then there is no reason for this business to have ownership interests publicly available – that is, they shouldn’t have stock for sale on the stock exchanges.

From where do the excess profits of publicly traded firms come? There are several sources.

The first is that publicly traded firms are very fierce competitors and frequently they drive smaller local and regional businesses out of business. In other words, the publicly traded firm isn’t really creating economic growth, instead they are feeding on the carcasses of weaker businesses. This is one reason that publicly traded firms report profit growth in excess of GDP growth.

The second source of profits in excess of GDP growth is innovation. Many publicly traded firms are constantly launching new products and new innovative products that capture greater wallet share or that create entirely new markets. This dynamic aspect of businesses is one of the predominate reasons to invest in stocks.

A third source of excess profits can come from the pricing practices of the business. Some businesses (i.e. monopolies or oligopolies) can raise their prices without offering a commensurate improvement in their products or without pushing up aggregate inflation.

Of the three sources of excess profits which do you think is the most important as a long-term investor? I think the innovation source is the most important for the long-term health of the business as the other two sources ultimately dead end at either a saturated, low growth market (source 1), or in economy-wide inflation or loss of customers (source 3). However, all three of the above reasons are good reasons to invest in the stock market.

The above three points also suggest a way of evaluating prospective investments. As you look at a potential stock market investment you can judge which of the three sources of excess profits the prospective investment is utilizing. Then you can evaluate the sustainability of the sources of excess profits. Does this make sense?

The above three points suggest our last axiom of why investing in the stock market makes sense.

Axiom 3: Publicly traded companies are fierce competitors and they typically earn excess profits by taking market share, innovating or raising their prices.

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Part 4 follows tomorrow.

Jason