Move over ASX dividend share traps, a new investing pitfall could now be luring profit seekers

The ASX share market is seeing a strong gain today. The S&P/ASX 200 Index (ASX: XJO) is up more than 2.5%. With all of this volatility, investors may be thinking that there are opportunities galore.

While some companies are higher today, I think it’s important to keep in mind that investors should focus on the long-term growth and profit potential of a business.

With interest rates up significantly since the start of the year, it may be unsurprising to see that some businesses are heavily focused on getting to breakeven and profitability.

I think there are at least two good reasons for that. The first is that the fall in share prices means that it’s not a favourable time to issue new shares and raise capital. Therefore, companies may need to manage their cash balances carefully.

Getting to breakeven could also be useful for businesses that want to pay down, or avoid, debt. Debt now costs a lot more with interest rates higher.

Should investors focus on ASX shares cutting costs?

It really depends on what’s being cut.

Being more efficient is a good thing. Slashing an advertising budget may help short-term profitability, but I don’t think it’s good for longer-term sales or growth.

Reducing research and development may help cut costs, but it could hurt the company in the long term if it fails to excite customers or it falls behind a competitor.

Discussing the economic situation on a NABTrade webinar, the Motley Fool’s Scott Phillips was asked which ASX tech shares come to mind when thinking about opportunities for companies to strip out costs and become highly profitable. He replied:

I don’t know about stripping out costs. I think growth remains the best path to value creation for most of these businesses. So I wouldn’t imagine a whole lot of them where just costs out are a long term answer to meaningful value creation. Doesn’t mean they can’t take some costs out of some businesses. We’ve seen Elon and Twitter — so you know, there are some businesses where we can take a whole lot of costs out…

So I think yes, some companies will make money by taking costs out. It’s probably moderate amounts of increased value. But you don’t want to take so much costs out you actually lose the growth opportunity.

I’m worried that companies are trying to be too responsive, in air quotes, to investor concerns right now of ‘I want to see profit. I don’t want to see growth anymore. Show me the profit’. I daresay most of those businesses probably would have been more profitable in 10 years’ time had they continued on the growth path, then pulling in their horns just to satisfy some freaked-out fund managers and investors who want short-term returns.

Phillips suggested that if businesses focus on short-term profit, then it would probably “come at the cost of long-term gains”.

What are some examples?

Well, I don’t have my crystal ball to know how things are going to turn out for some businesses making decisions during this period.

But, I think there are a couple of great examples of companies investing for long-term growth. For example, both Amazon.com (NASDAQ: AMZN) and Xero Limited (ASX: XRO) have prioritised putting money generated back into the business to grow further.

Not only does investing give Amazon and Xero the chance to earn returns on that investment, but it also reduces their taxes because the spending significantly reduces their taxable profit. If they weren’t investing so much, they would be much more profitable.

Amazon is now a major global power in e-commerce and cloud computing. Xero has become one of the world leaders in cloud accounting software.

But, sometimes a business doesn’t invest and it can end up being a lost opportunity. In my opinion, most of the 2010s were a missed opportunity for Telstra Group Ltd (ASX: TLS) to invest in other services, such as cybersecurity as one example. But, it seemed more focused on paying large dividends to shareholders rather than re-investing that cash.

Telstra’s profit and dividends sank after it lost control of the cable infrastructure following the sale to the NBN. But, Telstra is now investing, so hopefully that will pay off for the telco.

The post Move over ASX dividend share traps, a new investing pitfall could now be luring profit seekers appeared first on The Motley Fool Australia.

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More reading

• ASX 200 tech shares jump 6%
• Xero share price could rise almost 80%: Goldman Sachs
• 5 things to watch on the ASX 200 on Friday
• Why Amazon stock finished lower today
• Amidst the ongoing tech stock wreck, value shares are everywhere. There’s just one catch…

Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has positions in and has recommended Amazon and Xero. The Motley Fool Australia has positions in and has recommended Telstra Corporation Limited and Xero. The Motley Fool Australia has recommended Amazon. 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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