The "economic profit" strategy to picking winning stocks

Danial Jiwani is the author of Take Stock In This, which has been called “The Next Intelligent Investor” by readers. With the author’s books being read by Howard Marks and Bill Ackman, Jiwani is one of the leading thought leaders in the investment industry. Readers call it “the best book on investing since The Intelligent Investor,” according to Amazon reviews.

One of the arguments within the book is that successful stock picking isn’t about picking the right company. Rather, it’s about being exposed to the right industry.

The Importance of Picking The Right Industry

Imagine it’s 2004. You’re picking between investing in the four major U.S. airlines: Southwest, United, American, and Delta. 

How would you decide which airline to invest in? 

Perhaps the one poised to experience lots of sales growth. In that case, you might want to bet on Delta, which will triple sales. 

Perhaps the one with the strongest competitive advantage. In that case, you would want to bet on Southwest, which is known for having a low-cost advantage. 

Or perhaps the one with the highest gross margin by the end of the period. In that case, you would want to bet on United, which will earn gross margins of 34%. 

Or maybe even a diversified portfolio of all four airlines. 

Why not? 

You have each of their financial statements for the next 15 years, so you know that each of them will at least double or triple their sales volumes.

But here’s the catch. None of them actually made sense to invest in. 

If you invested in any of the major airlines over a 15-yearperiod from 2004 to 2019, you would have underperformed the market. American Airlines only grew 23% over the period, compared to 189% for the S&P 500. Delta Airlines and United Airlines underperformed the S&P 500 by 16% and 34%. The only airline that outperformed was Southwest Airlines, but by just a couple percent annually.

The airline industry illustrates an important lesson: industry matters. You can be right about the company, but you’ll still lose money if you’re wrong about the industry. 

A study once looked at the performance of more than 3,000 companies. They wanted to understand what factors drive a company’s level of profitability.

Does having a smart CEO drive a company’s success? 

Does company culture drive success? 

Or something else? 

What they found is that that industry matters more than anything else. In fact, the study pointed out that the average software company outperforms the leading construction companies because the software industry is so attractive. As the study concluded, “it’s better to be an average company is a great industry than a great company in an industry.”

Economic Profits: The Key To Picking The Right Industry

We know that the airline industry is one of the least attractive industries in America. From 1980 to the present, more than 90% of airlines have declared bankruptcy. And almost every single major airline has underperformed the S&P 500 over the past 15 years. 

But the interesting thing is that the industry checks out from a financial metrics standpoint:

• It earns decent profit margins, with a net profit margin of 4.9% pre-Covid. That’s roughly the same margins as one of the most profitable industries in America: the soft drink industry.

• It produces decent sales growth. Nearly all the major airlines have either doubled or tripled their sales volume over the past 15 years.

• It produces a healthy amount of earnings growth as well. Several of the major airlines have grown earnings by double or triple digits in the past decade.

That begs an interesting question: how could an investor conclude that the industry is unattractive if it checks out on so many key financial metrics? 

Well, there’s one metric where it fails miserably. 

And that one metric really, really matters: “economic profits.” 

The industry produces billions of dollars in economic losses every single year. Hence, economic profits are really the only metric that could tell you that airlines are unattractive. 

It turns out that “economic profit” is the only financial metric that can tell you which industries are attractive versus unattractive on a consistent basis.

Not profit margin. 

Not industry growth. 

Just economic profits. 

Economic profits represent how much value an industry creates. 

For example, an industry that earns $4 billion in economic profits is creating $4 billion in value for society. An industry that loses $100 million in economic profits is destroying $100 million in value for society. 

One of the reasons it’s the best measure of industry attractiveness is because it directly correlates with stock price performance. 

Years ago, Tim Koller did a study of more than 2,000 publicly traded companies. He found that economic profits were the most important predictor of stock price performance. 

In fact, a combination of economic profits growth and revenue growth was almost twice as predictive of stock price performance as earnings per share alone. That’s interesting because everyone focuses on earnings, but no one cares about economic profits.

Key Takeaways

• Take Stock In This is regarded as the best book on investing since The Intelligent investor by readers

• Picking the right industry matters as much as picking the right company

• Economic profits is the biggest predictor of industry attractiveness