The Globe and Mail, Report on Business
Published May 26, 2007

I started out writing this column about the most overused maxims in the investment business today.  I had lots of examples to discuss. 

“The massive amounts of capital will support the market for a while to come, even if valuations are unattractive.” 

This one sounds logical, but it’s amazing how quickly liquidity can disappear if returns aren’t there or momentum changes direction.  Then valuations do matter.

“This asset is more suitable in private hands than as a public company.” 

This is true of course, until the private owners see an opportunity to cash in some chips by taking the company public.  The initial public offering of a Vancouver favourite, Lululemon Corp., is an example of this.  It is going public just over a year after doing a private deal.

“Dividend-paying stocks are the way to go...you can’t lose.” 

Certainly this strategy has been successful so far this decade, but it truly has changed from being an investment strategy to conventional wisdom.  That tends to take away the appeal and significantly reduce the opportunity for above-average returns. 

There are other well-worn theories and maybe I will do a column about them another time, but what’s more interesting to me as an investor is what’s not being talked about. 

On the sell-side of the street, the aforementioned topics are where the buzz and revenue are, so they’re of paramount importance.  Takeover rumours generate trading activity and fees.  Announced takeovers generate even more fees for investment bankers.

However, on the buy-side – my perch since 1991 – the headlines are not particularly fertile ground for making money, although they do sometimes provide opportunities to go against the crowd.  

Money managers are paid to look beyond the stories of the day.  Their revenue comes from making their clients’ assets grow over the long term, not doing transactions or selling newspapers. 

Bill Miller, the revered portfolio manager of the Legg Mason Value Trust, likes to say: “If it’s in the papers, it is in the price.”  In that context, I want to highlight an important topic that isn’t garnering much print. 

There has been little focus on what really drives markets – profits.  While the attention is on other things, there is an underlying assumption that growing profits will be a continuing part of the investment landscape.  This view has pretty much become a given.  

When I read about the reasons why this liquidity-driven cycle might come to an end, rising interest rates, higher inflation and the demise of the Japanese carry trade are all routinely mentioned. 

These are key factors to be sure, but they pale in comparison to the level and direction of corporate profits. 

Private equity firms are competing against each other to buy public companies and lever them up with cheap debt.  If interest rates go up, the numbers won’t look as good.  But if the profits of the acquired firm falter, the value of the investors’ equity will disappear quickly. 

The same goes for Canadian income trusts.  Even though the focus around them has been on interest rates, yield levels and government policy, profitability continues to be the key.  To date, 25 per cent of all income trusts have cut or eliminated their distributions.  Profit deterioration has been the cause, not rising rates or the Finance Minister’s policies.

A synchronized world economy has been the biggest factor behind this profit growth.  But we already have a slower U.S. economy, and on the other side of the ledger, it is getting tougher to cut costs. 

And China’s rising currency and inflation rate may slow that country’s positive impact on corporate costs.  If enough tailwinds turn into headwinds, corporate profits may soon see their peak for this cycle.

Therefore, as an investor you should ask yourself, or your money manager, if the focus is enough on profits.