Business Analysis: Investors strike it rich on global profits boom

Corporate profits are soaring. Should firms invest the cash or return it to shareholders?
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The Independent Online

It was Calvin Coolidge, the US president during the 1920s boom, who said that civilisation and profits go hand in hand.

Based on recent experience future historians should look back on the past few years as a golden age for humanity. It would seem that profits are booming and in some cases are at, or approaching, record levels.

Companies as diverse as Legal & General, Hilton, Capita, Royal Bank of Scotland, National Express and Hanson, to name but a few, all announced 2004 profits yesterday that beat expectations.

The market has already been treated to a new record for UK profits, set by Royal Dutch Shell, which this month announced a £9.8bn annual return compared with HSBC's previous record of £7.7bn.

The profits boom is a global phenomenon. A report in December by UBS begged the question: "Can it get much better?" with profits from the G7 group of leading economies now worth 14 per cent of gross domestic product - easily a 25-year record - fuelled by negative real interest rates.

The bottom chart on the right, from Goldman Sachs, excludes profits from the financial sector and measures gross operating profits as a percentage of GDP. It shows how the US, UK and the leading EU economies of Germany, France and Italy have all enjoyed a profits bounce. In the case of the US and the EU profits are heading toward peak levels, although the UK is still a way off such toppy heights.

In Europe profits last year for the S&P Europe 350 companies rose 78 per cent but even companies struggling to grow sales are still producing good news. Nestlé, the world's biggest food company, yesterday announced a £1.8bn return to shareholders in the form of a share buy-back and dividend increase.

In fact shareholders across the globe are celebrating with huge amounts of cash pouring back into their funds from chastened management teams keen to increase dividends and share buy-backs rather than risk investor ire with the sort of ambitious expenditure projects that characterised the boom of the late 1990s.

Microsoft, Vodafone and BP are all examples of companies that are world leaders in their sectors choosing to boost payouts to shareholders rather than embark on potentially value destructive mega-deals.

Frances Hudson, an investment director at Standard Life Investments, said: "It has been returning cash to investors that has been rewarded by the markets. Share buy-backs and special dividends added 1 per cent to the dividend yield in the UK producing a 4.25 per cent yield on UK equities versus 4.6 per cent on gilts."

Georgina Taylor, European portfolio strategist at Goldman Sachs, said: "Last year global growth was stronger and we are now seeing that coming through in companies' profits. There was also a lot of cost -cutting still going on and companies have been reluctant to spend as well. The risks now are that companies will need to start spending some of this money and want to start investing. Secondly there is still pressure coming through with input costs going up."

The oil price and other rising raw material prices are a potential blip to the profits bonanza as is Goldman Sachs' forecast of a cooling in global growth this year to a trend level of 3.5 per cent - hardly a disaster but another negative along with the impact of a weakening dollar.

More outlay on capital expenditure and mergers and acquisitions is predicted but investors are not panicking, yet.

Although the US has seen a return to large deals, such as the $16bn (£8.5bn) acquisition of AT&T by SBC, the UK and Europe have seen more modest deals such as the bidding for the London Stock Exchange.

Ms Taylor said: "Because there has been such low investment there is an incentive now to acquire growth rather than do it organically. We are not talking about a massive rise in capital expenditure but we are looking at a recovery."

The cash returns that the profits boom has been fuelling are not likely to turn off overnight, however, as companies become suddenly profligate. "There is so much cash, dividends are not at risk. Companies have been risk averse recently as well so they will start to increase spending but they won't want to decrease dividends," Ms Taylor said.

But behind all the positive surprises on profits not everything is a picture of rude health, particularly in the UK. The fact that Britain seems to lag the EU and US in terms of the strength of its profits recovery is seen by some in the City as healthy because we might avoid dangerous overheating.

Economists also suggest that the extent of the UK's downturn after 2001 was not as deep as, say, Europe's and therefore the subsequent recovery not as steep.

However, the Confederation of British Industry sees something rather more sinister going on. By its measure, which includes the financial sector, UK profits are being squeezed. During the current economic cycle, UK plc profits peaked at 22 per cent of GDP compared with 25 per cent during the two previous cycles, which peaked in 1997 and 1985.

The CBI reckons this has cost £25bn in lost profits and one of the main culprits is higher costs imposed on companies by the Labour Government through taxation (up £40bn since 1997) and red tape.

Paul Niven, the head of strategy at F&C Management, the fund managers, reckons the US corporate sector has enjoyed higher productivity than the UK with the American workforce showing few signs of being able to flex its muscles. Europe, meanwhile, has a bigger exposure to a recovery in world demand than the UK on its own.

However, one lasting effect of the recent profits boom is that shareholders are more determined to allocate capital themselves by taking cash from flush companies and investing it in more needy growth stocks.

The lessons of the technology boom at the end of the 20th century may well have been learnt. President Coolidge's belief in the civilising effects of profits could yet come true for the early 21st century.

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