Quote of the Day: ROIC and the growth rate of corporate profits

The extraordinary thing is that Piketty’s analysis is based on a massive logical error. His thesis runs as follows: if R is the rate of return on invested capital and if G is the growth rate of the economy, since R>G, profits will grow faster than GDP, and the rich will get richer and the poor poorer. This is GIGO (garbage in, garbage out) at its most egregious. Piketty confuses the return on invested capital, or ROIC, with the growth rate of corporate profits, a mistake so basic it is scarcely believable.

Let me explain with an example. I happen to be a shareholder in an industrial bakery in the south west of France. It has a return on invested capital of 20%, but we cannot reinvest the profits in the company at 20%. If we were to reinvest the profits by putting more capital to work, the profits would not change at all, because nobody in the region is going to buy more bread and productivity gains there are non-existent. In other words, the marginal return of one more unit of capital put to work is zero. So instead of reinvesting in the bakery, we distribute the profits among the shareholders and they invest them elsewhere as they see fit. In short, our bakery has a high ROIC but no profit growth.

At the other extreme, a company expanding rapidly according to a “stack ’em high, sell ’em cheap” model might well show a low ROIC but very fast profit growth. Every company in the world can be “mapped” according to these two criteria: ROIC, and the growth rate of corporate profits.

Over the long term, the growth rate of corporate profits cannot be higher than the growth rate of GDP. That’s simply because if it was, after a while corporate profits would rise to reach 100% of GDP, which we all know is silly. Historically, the ratio of domestic profit to GDP has been a mean-reverting variable.

(bold original, italics mine)

This is from fund manager Charles Gave of the Hong Kong based Gavekal Research via Mauldin Outside the Box as published at the Valuewalk.com

Aside from addressing Picketty’s silly “inequality” issues, the above quote represents another demonstration of the natural limits of profit growth as I previously discussed. So be leery of people who peddle the supposed constancy of profit growth.

This also shows the dangers of "blackboard economics" in the context of policymaking and in investing.