The Future for Investors

by Jeremy J Siegel

  “You have to stop inventing things!” captures the essence of why technology can destroy value. All of the telecommunication innovations that fueled productivity and greatly enhanced our ability to transmit data also devastated profits, equity values, and many investors’ portfolios. It is yet another example of the growth trap, where a technology spurs productivity while it spurns profitability.

  The aftermath of the telecom bust was ugly: 360networks and Global Crossing, the firms touted by George Gilder, as well as Worldcom and 113 other telecom firms, filed for bankruptcy from 1999 through 2003.11 360networks, which spent $850 million to create one of the fastest fiber-optic lines across the globe, sold its fiber route for nearly 2 cents on the dollar.12 Jack Grubman, Salomon Smith Barney’s telecom analyst and the linchpin of their investment banking efforts, was ordered to pay a $15 million fine and banned from ever again working in an investment advisory firm.

  And the buzz about the future growth of Internet traffic that caused much of the overinvestment? It is a fascinating tale of how a single statistic—that Internet traffic would double every 100 days—became the Holy Grail for the industry, although it had no grounding in fact and virtually all the data contradicted it.13 In a bubble, hype becomes the truth, and hard facts that don’t fit the new paradigm are discarded as “irrelevant.”

  The Fallacy of Composition

  Investors and analysts alike who believed that productivity increases would lead to higher profits ignored a classic principle in economics called the fallacy of composition. Simply stated, this principle says that what is true for the parts is not necessarily true for the whole.

  Any individual or firm through its own effort can rise above the average, but every individual and firm, by definition, cannot. Similarly, if a single firm implements a productivity-improving strategy that is unavailable to its competition, its profits will rise. But if all firms have access to the same technology and implement it, then costs and prices will fall and the gains of productivity will go to the consumer.

  Warren Buffett, the world’s greatest investor, understood the fallacy of composition. When he purchased Berkshire Hathaway, a textile manufacturer, in 1964, the firm was losing money. But Berkshire was generating a lot of cash, and Buffett had high hopes that his managers could stop the bleeding. Most of the problems plaguing Berkshire, as well as all other textile manufacturers, stemmed from high labor costs and foreign competition.

  To combat these problems, Berkshire’s management continuously presented Buffett with plans that would improve its workers’ productivity and lower the company’s costs. As Buffett noted:

  Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable investments in our highly profitable candy and newspaper businesses.

  But Buffett never accepted a single investment proposal because he understood the fallacy of composition. Buffett knew that these improvements were available to all textiles companies and that the benefits would ultimately flow to his customers in cheaper prices, not to Berkshire in higher profits. As Buffett remarked in his 1985 annual report:

  [T]he promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.14

  Buffett would have liked to have sold this textile business to someone else, but unfortunately, most other investors came to the same conclusion. He had no choice but to close Berkshire’s doors and liquidate his textile operations, retaining only the name of what was to become the world’s best-known and best-performing closed-end investment firm.

  Buffett contrasts his decision to close up shop with that of another textile company that opted to take a different path, Burlington Industries. Burlington Industries spent approximately $3 billion on capital expenditures to modernize its plants and equipment and improve its productivity in the twenty years following Buffett’s purchase of Berkshire. Nevertheless, Burlington’s stock returns badly trailed the market. As Buffett states, “This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise.”15

  This “faulty premise” is not limited to the textile industry. There is strong evidence that firms with the highest level of capital expenditures suffer the worst performance across the entire stock market. Five portfolios are formed, ranging from the firms with the lowest to the firms with the highest capex to sales ratios. The portfolios are rebalanced each December 31 using the last twelve months’ sales and capital expenditures. Figure 7.1 shows the cumulative returns of the firms with the highest and lowest capital expenditures (capex) to sales ratios relative to the S&P 500.16

  The results are a blow to those who believe that capital expenditures drive profits. Those firms that engaged in the most capital expenditures provided investors with the worst returns, while those that had the lowest expenditures had overwhelmingly better returns—more than 3.5 percent per year higher than the S&P 500 Index over almost half a century.

  Many on Wall Street believe that capital expenditures are the lifeblood of the productivity revolution. But the truth is that most capital expenditures provide investors with poor returns. It is so easy for management to be talked into expenditures because “everyone else is doing it.” But as consumer demands and technology shift, today’s grand projects become tomorrow’s dinosaurs. Firms are left with a legacy of debt and, finding themselves strapped for funds, discover that they have less rather than more flexibility to meet future needs.

  FIGURE 7.1: RETURNS TO S&P 500 FIRMS SORTED BY CAPITAL EXPENDITURE/SALES RATIOS, 1957–2003 (SOURCE: COMPUSTAT®)

  Capital Austerity and Profligacy

  Of all ten market sectors, the two with the highest ratios of capital spending to sales are the telecommunication and utilities sectors; and, save for the materials sector, they also had the poorest returns. From 1957 through 2003, the telecoms had a capex-to-sales ratio of almost .28 and the utilities had a ratio of .25, as compared to under .10 for all the firms in the S&P 500 Index. In contrast, the best-performing sector, health care, had an average capex to sales ratio of only .07, and the second-best sector, consumer staples, had the lowest ratio, .044.

  I wrote about the telecommunications boom and bust at the beginning of this chapter. The capital spending spree on fiber-optic cable bankrupted much of the industry. The utilities suffered a similar fate in the 1970s and 1980s when a capital spending spree on nuclear power plants sent a number of firms into or near insolvency.

  These results hold for individual firms as well as industries. Returns to investors when a firm is in the highest group of capital spenders is often far lower than when it restrains capital expenditures.

  AT&T had average returns of 9.11 percent when it was in the highest-spending group but a return of over 16 percent when it was not. Procter & Gamble spent twenty-eight of the last forty-six years with average capital spending and delivered a healthy return of 17 percent per year during those years. But in the six years it was in the highest-spending group, its returns averaged a measly 2 percent, while in the twelve years it was in lower-spending groups, its returns averaged 19. 8 percent per year.

  Companies with strong brand-name products are not immune to the deleterious effects of high capital spending. Gillette, the famous producer of razor blades, had middling capex ratios for twenty-five years and averaged returns of 16. 6 percent during this time. But during
the seven years Gillette was in the higher-than-average expenditure group it had negative returns, and when it was in a lower-than-average group its returns averaged an amazing 26. 4 percent per year. A similar story could be told for Hershey.

  The retail giants Kmart, CVS, Woolworth, Kroger, and Allied Stores all showed dramatic differences in their returns when they were in the low-capital-spending group versus when they were not. Kmart’s average return was over 25 percent per year in the twenty-five years it was in the lowest-capital-expenditure quintile. In sharp contrast, in the nineteen years when the retailer was not in the lowest quintile, it had average returns of −3.8 percent per year.

  The negative impact of capital expenditures on stock returns extends to many subindustries. Since 1984, the energy sector has had fairly high expenditure ratios and overall good returns. But when you go beneath the surface you find that the oil and gas extractors, which had very poor returns, had a huge .225 capex-to-sales ratio, while the integrated “big oil” firms, which performed very well, had a more modest .10 ratio.

  Technological Growth

  Historical economic data indicate that the fruits of technological change, no matter how great, have ultimately benefited consumers, not the owners of firms. Productivity lowers the price of goods and raises the real wages of workers. That is, productivity allows us to buy more with less.

  Certainly, technological change has transitory effects on profits. There is usually a “first mover” advantage. When one firm incorporates a new technology that has not yet been implemented by others, profits will increase. But as others avail themselves of this technology, competition ensures that prices fall and profits will revert to normal.

  This is exactly what happened with the introduction of the Internet. At first, many analysts figured the Internet would boost profit margins since firms would be able to lower their costs of procurement, inventory, and data retrieval because of the Internet’s ability to facilitate business communications. But the Internet did not increase profit margins substantially, and in many cases it actually decreased them. Why? Because the Internet has made all our markets more competitive.

  A More Competitive Economy

  In order to understand the Internet’s impact on corporate profits, one must recognize how search costs—the time and dollars spent by consumers (or businesses) to find a cheaper price for the goods or services they are buying—enter the profits equation.

  In years past, sellers knew that if they could draw the customer to their stores, they had won most of the battle. The corner drugstore could mark up goods that were in demand because it knew that it was unlikely that consumers would spend costly time to shop for cheaper alternatives. Convenience and location became critical factors in marketing goods.

  But the Internet sharply reduced the costs of searching alternatives and changed the game dramatically. Many of the advantages of location and convenience enjoyed by firms disappeared. Suddenly the consumer had available a full array of prices from many different providers. Price transparency vaulted price competition into the spotlight.

  I vividly recall an episode a few years ago when my son, then in high school, needed a calculator for school. We priced it on the Internet, using one of the many price search engines available. The price at Staples, the store closest to our home, was by no means the cheapest. Yet we printed out the prices found over the Net and brought them to the store. When I showed the clerk that a competitor had the same item for a cheaper price, he immediately offered to match it. Considering that the margins on retail sales are already paper-thin, it was likely that the price we received was at or below Staples’ cost.

  The Airline Industry

  The airline industry provides another example of how technological advances such as the Internet reduced profits.

  The Internet enabled online travel companies, such as Orbitz and Expedia, to sell cheap seats on the Web that formerly had been sold to consolidators who would resell the tickets through toll-free numbers. But the airlines believed they could also engage this technology. They saw the Web as a way to squeeze both these consolidators and travel agents, to whom they paid commissions.

  Jeffrey Katz, the CEO of Orbitz, said in July 2000 that selling and marketing tickets was one of the airlines’ biggest costs, and “most of the airlines that looked at the Internet [saw] potential distribution cost savings of around 50 percent.”17

  By the fall of 2002, airlines were well on their way to replacing agents with online bookings, which surpassed 20 percent of all sales. The Internet allowed the airline industry to shed about $2 billion from its cost structure from 1998 through 2002.

  But instead of celebrating these remarkable cost savings, the airlines were plagued by unsettling developments. The Internet provided travelers with tools to search out the cheapest fares.

  This was an entirely different ball game. In the past, the computer software that airlines’ ticket agents utilized did not use price as the primary criterion. Convenience of schedule and minimizing time en route were the most important factors for business. But as travelers became more cost conscious, they searched for cheaper alternatives, which often can be attained with just minor shifts in the schedule. The result has been a steady reduction in the average price of the tickets and an erosion of airline profits.

  Airline analyst Jamie Baker of J.P. Morgan Securities summarized the situation:

  The Internet and its inherent pricing transparency may ultimately cost carriers more in lost yield than it saves in distribution expense. Combined with a growing discount sector, the Internet is expected to significantly retard any improvement in industry pricing that would otherwise accompany a strong economy or a gradual relaxation of corporate travel restraint. For anyone anticipating a return to the yield levels of 1999 and 2000, we would suggest you’ve underestimated the role of the Internet.18

  It is striking how easily the Internet can cannibalize profits. Instead of boosting earnings, the Internet levels the playing field and increases the ability of consumers to find the best prices. Certainly firms can and will compete on the basis of service, immediate availability, return policy, and so on. Yet no one can deny that price transparency makes retail distribution much more competitive.

  Technology from a Manager’s Perspective

  To many, technology seems to be the key to success. The ability to produce goods more efficiently seems like the answer to sagging profits. But this is not the case.

  Rigorously questioning expenditures is something not enough companies do well. Jim Collins, in his best-selling book Good to Great, asked, “Do you have a ‘to do’ list? Do you also have a ‘stop doing’ list? … Those who built the good-to-great companies, however, made as much use of ‘stop doing’ lists as ‘to do’ lists. They displayed a remarkable discipline to unplug all sorts of extraneous junk.”

  Collins interviewed the CEOs who turned their companies around into winning investments. “Across eighty-four interviews with good-to-great executives, fully 80 percent didn’t even mention technology as one of the top five factors in the transformation.”19 And when executives did mention technology, its median ranking in importance was fourth, with only 2 percent of the executives listing it at number one.

  For the best firms, technology plays a supporting role, enhancing the company’s core competencies. Capital is the source of productivity, but it must be applied in moderation. Too much capital spells the death of profits and the destruction of value.

  CHAPTER EIGHT

  Productivity and Profits:

  WINNING MANAGEMENTS IN LOSING INDUSTRIES

  As a place to invest, I’ll take a lousy industry over a great industry anytime. In a lousy industry, one that’s growing slowly if at all, the weak drop out and the survivors get a bigger share of the market. A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market.

  —Peter Lynch, Beating the Street, 19
93

  One traditional investment approach begins by examining an industry expected to have a bright future, and then selecting a company that stands to prosper from this growth. But this type of investment approach eliminates some very prosperous firms in stagnant or declining industries. In fact, some of the most successful investments of the last thirty years have come from industries whose performances have been utterly horrendous.

  These companies have bucked the trend. They all rose above their competitors by following a simple approach: maximize productivity and keep costs as low as possible.

  These successful firms employed very disciplined and focused capital expenditure and investment policies. They judiciously selected the capital expenditures that matched their unique competitive strategies. Unlike “capital pigs,” which spend their money unproductively, these companies find investments that complement and enhance their core competencies.

  Past success does not guarantee the companies discussed in this chapter will perform well in the future. In fact, each of these firms has encountered headwinds in its pursuit of expanding profits. Nevertheless, it was superior management—not technology—that produced superior investor returns.

  The Airline Industry: Southwest

  Investors have lost more money in the airline industry than in almost any other. When Warren Buffett was asked why he invested $358 million in USAir in 1989, he snapped back: “Well, I think probably the best answer is temporary insanity.… So I now have this 800 number, and if I ever get the urge to buy an airline stock I dial this number. And I say my name is Warren, and I’m an ‘air-o-holic,’ and then this guy talks me down on the other end.”1