One big lesson from earnings season

There is a lot to take in.

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Well, earnings season is over for another six months. And there was a lot to take in.

(Quick plug: Members of Motley Fool services can expect some additional video content on earnings season over the next few weeks, so stay tuned!)

But one thing seems very clear. Unfortunately for many, I think 2024 will be a year of significant cost-cutting across the economy.

Frankly, we're already seeing it, with Optus, ANZ Group Holdings Ltd (ASX: ANZ), Westpac Banking Corp (ASX: WBC), BHP Group Ltd (ASX: BHP) and others. And outside the ASX, Paramount Global (the owner of Channel 10) is doing the same. And they're just for starters.

Why? Well, it's the old story.

Sales growth is hard to come by. Inflation is pushing up costs across the board. And with business owners (including public company shareholders) looking for profits to be maintained or increased, that puts cost-cutting front and centre.

For employees, that's grim news. The easiest costs to cut tend to be staff costs (once you've frozen discretionary spending on things like travel and events).

In part, it's why the RBA and Treasury are expecting the unemployment rate to rise during the year: a slowing economy will have that impact, both on volume (businesses going broke) and cost-cutting grounds.

And for investors? What are we to make of the economy and market we're in at the moment?

Well, I'd start with the observation that economic cycles aren't new. They might have been sleeping, but turns out this particular parrot wasn't dead after all.

It's one of (the only?) benefit of getting old: we've seen this movie before.

The opportunity for the true long-term investor ('long term investor' should be a tautology, by the way, but sadly isn't always) is to play that out. We may be near the bottom of the cycle, but that means – by definition – that there are better times ahead.

No, not for every company. Not even for every sector. But overall, a recovering economy will see the better companies grow sales and profits.

And it's where the idea of 'thinking like a business owner' comes in.

I've used this analogy before, but let's say you wanted to buy a cafe. The cafe's sales have been falling, because roadworks have impacted parking and access. Profits have fallen even faster, because a lot of its costs are fixed, even after it has reduced staff numbers.

Now, it's possible that the roadworks are so disruptive that the cafe goes broke before they're finished. You can't rule out that possibility.

But it's also likely that, as a cafe in a good location, with loyal customers and decent-but-not-exceptional competition, it recovers when the roadworks are finished, and profits return to normal.

If you were going to buy the cafe, what would you base your purchase price on? You might not want to assume a 100% chance of full recovery, of course, but if the owner was selling it cheaply, based on the temporary lull in earnings, you'd probably jump at the chance to buy.

The benefit of buying a private business, of course, is that you don't have someone constantly telling you what they think it's worth between 10am and 4pm, 5 days a week.

You can focus on the business, and the recovering profits, relative to the price you paid.

Don't get me wrong: being able to sell my shares at a moment's notice is a pretty compelling reason to buy and sell on the ASX. But the downside is that constant price quotes tend to mess with your head.

We've already seen some share price recovery, by the way, for many retail companies, as investors (belatedly) realise the long-term will be brighter than the recent past or the near future.

But not all. And not completely.

And by the way, this is a great time to remind yourself that cycles have peaks, too. Yes, it might feel a long way away, but just as you shouldn't assume a cyclical low won't last forever, be careful not to get carried away at the peak, when it comes!

I also want to go back to that cost-cutting thing, too, with an observation that I don't think is made often enough.

The share market tends to cheer companies that cut costs, hoping to collect the higher profits that come as a result. But managers shouldn't be too roundly cheered.

See, while some labour costs are directly volume-related (you might need fewer warehouse workers if there are fewer boxes to be put on trucks), many/most aren't.

So, if a CEO is cutting those staff, today, one of two things is true. Either:

– Those people shouldn't have been hired/kept on in the good times, and the business was mismanaged and bloated; or

– The cost-cutting is too extreme, and those people are actually needed for long-term success, meaning the CEO is putting short-term profits ahead of long-term value creation.

Sure, a cafe can fire the barista and the cook, and bet/hope that they'll be able to replace them with similar or better people when the good times return. But if the coffee and the food suffer, the customers might just go elsewhere.

I'm not saying all cost-cutting is bad. Or that companies should keep people on staff who aren't contributing equal or greater value to what they receive in compensation.

Just that we should be careful what we wish for – and what we're happy to see. As a business owner (because that's what we are, as shareholders) I'd far rather my company carry good people in the bad times, so it's ready to rebound, strongly, when good times return, rather than jettison them, and roll the dice on recovery.

Yes, that means the company needs to have the financial ability to carry those costs. But also, do you really want to own shares in a mob that is so stretched, its very survival is at risk?

No. Me either.

Fool on!

Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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