Friday, 5 September 2014

Where the profits come from

In the last couple of posts I've been looking at the profitability of different sectors of New Zealand business, using the data from Stats' latest Annual Enterprise Survey.

For some reason the fascinating data in the Survey don't seem to get a great deal of airtime, so partly to make the case for greater use of it, and partly because the trends in the data are fascinating, and as a little bit of a public service (the numbers need a degree of assembly), I've pulled together this composite picture of business profitability over the past five years.

I've broken down some of the line items into sub-sectors where it seemed interesting, though there are still lots of sub-sector alleyways I haven't gone up, for example within agriculture and manufacturing. And in some sectors I've split out an "ex government" breakdown (eg in education and health where government is a big player) to get a better feel how private business is faring in those sectors. Profitability, by the way, is pre-tax return on equity. The years are financial years ending in March.

You'll see the unsurprising effect of the overall business cycle on profitability: ROE across all industries was only 6.2% in recessionary 2008-09, and has worked its way higher to the latest 9.1% (and I wouldn't be surprised if it edged higher in 2013-14). There may be additional cyclical stuff going on in the manufacturing ROE too: I wonder if that fall in the 2013 year was down to the impact of the high Kiwi dollar?

And you can see the impact of the Canterbury earthquakes in the 'health and general insurance' line, which took a hammering in financial 2011 and 2012. You see it again, less directly, in the ROE on residential construction in 2013, which rose to extravagant levels. There's quite a bit of year to year volatility at a sub-sector level, so I wouldn't read volumes into the latest reported 48.4% ROE on housebuilding, but whatever the number is, it's clearly happy days in the building trades.

Generally the pattern of profitability is much as you might expect a priori, with (for example) the utility/infrastructure end having a relatively low ROE. I'd hoped to unpack that 'information media and telecoms' line a bit more to see the infrastructural component, but confidentiality issues mean that Stats was only able to release a breakdown for 2013, so I flagged it away.

As I've noted before, some of the returns look on the high side for the kind of business they are - wholesaling, retailing, and construction in particular (the ROE on the various parts of construction was quite high even before the earthquakes). At a blind guess, before seeing the data, I'd have picked their ROEs as somewhere around the mid teens, but they're well north of that. It's hard to go past the thought that these are all non-tradable sectors that don't face the degree of competitive pressures more trade-exposed sectors like manufacturing have to cope with.

And while I'm open to anyone who can show some other realistic explanation of the high returns in these domestic sectors, I doubt that there's enough domestic competition to adequately constrain ROEs, either. Look at the comparison with the banks, for example: there are some sceptics who wonder about high profits from a banking oligopoly, and it was the explicit premise behind the formation of Kiwibank, But the returns from wholesaling, retailing and construction are all substantially above the ROE in banking, even if you take a generously high view of the banks' ROE (15.8% in the latest year).

The professional services sectors show an interesting pattern, too. The reported ROEs for the likes of science, architecture, doctors and vets, IT professionals, and lawyers and accountants are all quite high. And I don't have a problem with that (always assuming that the high ROEs aren't the result of gatekeeper restriction on supply). You'd expect it: these are scarce, often highly specialist skills that you'd imagine can command high returns as high productivity inputs.

But clearly there's something odd in attributing all of the return to the monetary capital invested in the business. The reported return on shareholders' funds grossly exaggerates the return on the capital invested, as it conflates the return to the tangible assets with the real source of the high returns - the intangible capital between the professionals' ears. And in turn that makes me wonder about some of the conclusions that Thomas Piketty comes to in Capital in the Twenty-First Century, where that 'high' rate of return on capital that he quotes must also be inflated by including returns that should more properly be attributed to a different factor of production. And the inflation will be getting worse as high knowledge activities progressively account for more of a modern economy
In any event, that's only one of the ideas that might come to you when you start using this data. There's lots more there - I've chosen to focus on ROE, but you could look at sales or profit per employee, balance sheet structures, margins on sales - so if you've got an interest in the performance of New Zealand business, tuck in. It's an invaluable resource.


  1. John Polkinghorne9 September 2014 at 13:21

    Hi Donal, thanks for two interesting posts on this rich data source. I've got a couple of notes on some of the points you raise - firstly, ROE will be high for service businesses generally because, as you point out, they rely largely on human capital rather than physical capital which shows up in equity. I could go and run an economics consultancy from home with essentially no equity, or set up in an office with not much more.

    Retailers' figures will be inflated to some extent by seasonal factors - their working capital requirements are higher in December, lower in March/ June which is the usual end date - and it's also just the nature of the industry, constantly changing with fairly high risks and rewards. Also, these days it's quite rare for retailers to own their own premises, so that's another structure which reduces capital requirements (while also imposing future liabilities...)

  2. Thanks John. You're right, services businesses will tend to be light on physical capital and that will increase ROE, and sale and leaseback of premises will do it, too. You could be right as well about the seasonal factor affecting the measurement. On the "fairly high risks and rewards": you may have a better feel for the retail trade than I do, but my initial instinct was that the risks down the food and grocery end weren't down the higher end of the spectrum.

    You're right about the rich data source, too. If I had endless time and money I'd love to get to grips with the determinants of the profitability of NZ business, and the AES is a real treasure trove.


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