The SMS conference reminds me of a long-standing puzzle. We have known for decades that investors value growth in earnings – because they either get rising dividends or a rising stock price they can sell on. Profitability – return on sales or on assets – is only of interest insofar as it enables future earnings growth. So how come the strategy field is obsessed with ‘explaining’ why some firms are more profitable than others, when investors aren’t interested and management does not pursue it?
One very common result is that firms may be less profitable, or even unprofitable, for many years, but still enjoy investors’ confidence and a strong share price. This support reflects the expectation that earnings will grow, even if they are not doing so yet. So I’ve asked now in 3 sessions here in Cologne why empirical research in academia hypothesises that ‘performance’ reflects some factor X, and then sets out to confirm that hypothesis correlation between factor X and profitability [ROS, ROA etc]. So far, I don’t get an answer that makes sense. The only attempt I heard was that “We are trying to explain ‘sustained competitive advantage’, and that is indicated by superior profitability.”
To illustrate the nonsense this gets us into – Amazon.com was loss-making for many years, and still generates rather modest profitability. Every time they could have become more profitable, they found further opportunities for growth. So if you took the academic logic, you would be trying to explain why Amazon.com has been an unsuccessful business !
‘Sustainable competitive advantage’ is important of course – if only we knew what it was. I’d go for ‘the ability to sustain stronger growth in earnings than other firms’, which is what managers seem to seek and investors value.[ Strictly, investors value ‘free cash flow’ – the cash flow generated after the business has spent what it needs to grow – which is why they can be reasonably upset when firms with limited growth opportunities throw their cash away on ill-advised acquisitions. ] Share