22 Oct 2019

Why earning profits is the essential task of business

Professor Brian Kantor

Investec Wealth & Investment

The modern corporation is wrongly under attack for failing to assume a role that it was never designed to take.

One of the pleasures of my career is to listen to the accounts of great business enterprises, as told by their CEOs and CFOs to conferences of investors. They seldom fail to impress with their sure grasp of the essentials of business success in a complex world – a world that contains the threat of competition from close rivals and even more dangerous, the disruption of their business models and their relationship with customers, from quarters previously unknown.  They are in it for the long run. Short termism clearly does not make for business success.

In order to scale the advantages of their intellectual property and culture, they must have a global reach, something that inevitably includes managing successfully in China, with all its opportunities challenges and trade-offs.

They sense the growing opportunity that data collection and analysis offers to produce, distribute and market their goods and services more efficiently. In order to scale the advantages of their intellectual property and culture, they must have a global reach, something that inevitably includes managing successfully in China, with all its opportunities challenges and trade-offs.

 

They are well aware of meeting the demands society and governments make on them for them to be allowed to operate legitimately. They know they have to play by rules over which they may have (too) little influence.

 

And one senses from them a new urgency about a disciplined approach to the management of shareholders’ capital. Business success and the performance of managers is increasingly being measured by (internal) returns on capital employed, properly calibrated, in a way that adds value for investors.

 

The success of the developed world in raising output and incomes – consistently improving the standard of living – is surely attributable in large part to the system design that accords so much responsibility to businesses large and small. The improvement in the average standard of living, in the major economies and of those of their least materially advantaged in the bottom quartile of the income distribution (helped by taxpayer provided welfare benefits) has been at a historically unprecedented rate over the last 70 years or so.

 

While the rate of economic improvement may have slowed down in the past two decades, it sustains an impressive clip. Over the past 20 years GDP per capita, in constant purchasing power parity terms, in the largest seven economies (G7) as calculated by the IMF, has grown by a compound annual average of 2.8%. Over the past 10 years this growth rate has slowed only marginally, to an average of 2.7% a year, a rate rapid enough to double average per capita incomes every 26 years or so.

One might have thought that the proven capabilities and potential of the modern business enterprise would enjoy wide appreciation and respect for its ability to deliver a growing abundance of goods and services that their customers choose. This is especially the case for products and services that were unavailable or inconceivable to earlier generations before, thanks to innovations and inventions sponsored and nurtured by business.

 

And in doing so they have provided well-rewarded employment opportunities to so many while providing a good return to their providers of capital – both debt and share capital. A large majority of them, directly and indirectly, are anything but rich plutocrats. They are the many millions of beneficiaries of savings plans, upon which they rely for a dignified retirement.

 

But this wide appreciation appears to be lacking. The modern corporation is under attack for its many alleged failures, as highlighted by a recent op-ed by Martin Wolf in the Financial Times (“Why rigged capitalism is damaging liberal democracy” 18 September 2019). It is surely a misrepresentation to see the beneficiaries of the modern corporation as rentiers with a generous, guaranteed source of income secured by some conspiracy that protects firms against competitive threats.

“What are they doing to ensure better laws governing the structure of the corporation, a fair and effective tax system, a safety net for those afflicted by economic forces beyond their control?”

Wolf would have the leaders of the large modern corporation accept much greater responsibilities for the (apparently) failing economic condition. He asks of the leaders of corporations, “What are they doing to ensure better laws governing the structure of the corporation, a fair and effective tax system, a safety net for those afflicted by economic forces beyond their control, a healthy local and global environment and a democracy responsive to the wishes of a broad majority?”

 

This is to ask them to assume the essential role of governments. They are not fit for this purpose. Governments make the rules that firms have to observe and manage as best they can.

 

The firm however, has been entrusted by society with an all-important economic function, which is to assume responsibility for the allocation of its scarce resources. Their job is to exercise the right to utilise human and natural resources and the stock of savings for which firms must compete.

 

Earning profits provides the essential discipline to prevent the potential waste of valuable resources with alternative uses. Exercising its freedom of action and earning a profitable return on capital, is the firm’s essential justification – if, that is, we are to preserve our successful economic way of life.

About the author

Brian Kantor headshot

Prof. Brian Kantor

Economist

Brian Kantor is a member of Investec's Global Investment Strategy Group. He was Head of Strategy at Investec Securities SA 2001-2008 and until recently, Head of Investment Strategy at Investec Wealth & Investment South Africa. Brian is Professor Emeritus of Economics at the University of Cape Town. He holds a B.Com and a B.A. (Hons), both from UCT.

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