Illusory Margins
Somebody came at me the other day with a variant view on my stance that high profit margins are good.
What this person said was that high profit margins are bad. Because labor is going to figure out you’re underpaying them, customers that you’re overcharging them, competitors what you’re doing and copy it, and the government that they should regulate it. So your margin either won’t persist or won’t scale. But either way your high margins are inviting adversity.
Around the same time, I read this Greg Ip column about how the riches of the modern economy are accruing more to capital than labor, pointing out that shareholders are doing great while “the average worker ekes out marginal gains.”
Maybe I don’t have this right, but shouldn’t some version of that be the case?
After all, capital is what’s signing up to take losses if things don’t go right. Labor can end up in a bad spot – layoffs, missed checks, bad bosses – but typically can’t end up owing anyone anything. The reason capital has more upside than labor is the same reason equity has more upside than debt, which has more upside than treasuries. Return comes from risk. If you don’t take it, you won’t make it.
Mr. Ip did, however, point out something interesting and relevant:
Gross domestic product measures all the value added in the economy. For example, the value added by a manufacturer is its sales minus inputs such as parts and raw materials. That value is then distributed either to labor as wages and benefits, or to capital as profits and interest. Some value added is also allocated to depreciation, the cost of replacing assets as they wear out or become obsolete.
This is a reminder that accounting profits are what’s left after you’ve paid your people and set aside enough for keeping your machines from rusting out.
Which brings me to a chart our CEO Brent recently sent me showing that Meta, Google, Amazon, and Oracle (all allegedly high margin businesses) will be spending more in capex this year than they will earn in operating profits.
Something I’ve been wondering is if all of this technology we’re spending on is going to become obsolete a lot more quickly than we’re accounting for. And if the modern economy is increasingly capital intensive, whether or not that’s a bad or good thing. One can argue, reasonably, that reinvestment is progress, expensive as it may be.
Moreover, all of the people crowing today about how much money they are saving by replacing people with AI might be wise to note that the technology they are leveraging to reduce cost is losing money for the people developing it. But it couldn’t be the case that someone might get you hooked on something and then jack up the price.
So what about those high margins?
I will never agree they’re bad (and can show examples of persistence at scale), but I do think that, in some cases, they’re illusory. Because where’s the beer money?
– Tim
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