Weekly Commentary November 1, 2019
In the last couple of years, U.S. companies have posted record-setting earnings as a result of corporate tax cuts and economic expansion. The earnings growth rate of the S&P 500 was just over 20 percent in 20181, and estimates project that number to be in the mid-single digits in 2019.2
However, new disruptive competition is forcing some companies to drastically reduce pricing, and therefore, their earnings. Most recently, disruption occurred within the investment industry as several large brokerage firms announced the elimination of commissions on online stock trades.3 This was an attempt to head off competition from Robinhood and other “free” investment platforms. Similarly, the brick-and-mortar retail markets have been upended by Amazon’s prices while companies like Uber and Lyft have caused price wars in the car hailing and rental markets.
This is not a new business strategy. For years, companies have tried to gain market share through unprofitable pricing or the use of loss leaders.4 It is new, however, that so many companies (and their investors) are willing to be unprofitable for up to a decade or longer. One reason for this is the large amount of cash that private equity and venture capital strategies have amassed in recent years. Cash must be deployed and is finding its way into businesses that investors likely would have rejected in prior years. This cash has kept many companies alive and allowed them to continue their strategy of pricing core services well below cost.
Over the last several years, the market has been patient with unprofitable companies, but that won’t always be the case. Take, for instance, the abandoned IPO for WeWork5, which until very recently was an industry darling. GrubHub is another company that has priced its services well below cost and, this week, saw its stock cut nearly in half as investors begin to doubt whether the company can ever turn a profit.6
One huge winner in all of this has been the U.S. consumer. As consumer technology companies have offered free or low-cost services, inflation has remained low7 and consumers have gotten a pretty good deal with investors picking up the tab.
However, this likely won’t last. Investors will separate their charitable giving from their investments and consumers may eventually discover that free pricing means they are paying in other ways.
As 2019 comes to a close, we will continue to watch this trend. With the big earnings bump in 2018 and much smaller growth projected for 2019 and 2020, we’ll see how long cash will continue to flow into the unprofitable.
1. Multpl.com – S&P 500 earnings growth rate by year
2. S&P Dow Jones Indices – Earnings estimates
3. CNBC.com – The end of commissions for trading is near as TD Ameritrade cuts to zero, matching Schwab
4. Investopedia – Loss leader strategy
5. Reuters – WeWork throws in the towel on its ill-fated IPO
6. CNBC.com – GrubHub shares crater more than 40% after a terrible earnings report causes analysts to bail on the stock
7. US Inflation Calculator ¬– Current US inflation rates: 2009-2019
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