Buy High Sell Low Macro Trends and Inferences
1. Capital markets provide more financing than necessary. When it comes to selling money, Wall Street and financial markets tend to reward innovation and new ideas. Entrepreneurs, having reaped the rewards of successfully developing a new business, find their wake littered with financiers eager to offer imitators bigger and better financing packages. History has shown that financial markets are willing to finance (and customers are eager to embrace) second and third-tier competitors—the former are financed for the investment opportunity and the latter for the potential to reduce and bid away monopoly profits. As new competitors enter the marketplace, overall profitability decreases and the potential for meaningful returns diminishes (unless new entrants have advantages such as geographic or governmental monopolies).
Think of hamburgers. In the mid-1950s, McDonald's introduced the revolutionary concept of fast food dining. Over the next 40+ years, the convenience of fast-food hamburgers mushroomed into a multi-billion dollar industry, with McDonald's, Burger King and Wendy's emerging as the industry leaders. When these companies were established, they fulfilled an important consumer need. Subsequently, with increasing consumer demand and available financing, these three national competitors (along with dozens of other non-hamburger chains) became fixtures of everyday life. However, the increasing competition reduced growth rates and curtailed profitability to the point where an investor today would be hard-pressed to fund a new fast-food chain with any expectation of mirroring the returns early McDonald's investors achieved.
New technologies, especially when presented as stand-alone investment opportunities, are bound to have exceptionally high failure rates.
Think of telecommunications. During the 1990s, investors, encouraged by new technologies and the apparent insatiable demand for communication services (with Wall Street's assistance), provided enough capital to fund every seemingly reasonable telecom project. The growth assumptions underlying Wall Street's capital-raising activities seemed to assure that each project would mirror the early successes of MCI and Sprint, AT&T's first major competitors.
However, investors missed the bigger picture. In financing the telecom industry throughout the 1990s, investors failed to grasp the macro environment where the total capacity under development or construction was so great that it would not be used for years. A critical industry analysis would have considered the following: How many different telecom services were needed? How many new telecom services and telephone lines would businesses and individuals utilize? What new services and price points would encourage consumers to change over to new competitors? And how would existing telecom providers react? But the "story" preferred by Wall Street, telecom issuers and even investors was the micro vision of success without incorporating the macro scrutiny indicating excess capacity and ephemeral profitability.
Inference: Immoderate access to capital often results in unwarranted investments leading to inferior or even negative returns, especially when the excess capital is focused in a specific industry. When this occurs, it usually is measurable and may be a strong indicator of declining future profitability.
2. Capital markets finance improvident acquisitions. The success of private equity LBO investments throughout much of the 1980s, with long-term rates of return in excess of 20 percent, created billions of dollars of available capital for the LBO progeny of the 1990s, and with it increasing competition for acquisition candidates. In order to achieve a competitive advantage, many private equity firms adopted a series of acquisition strategies, including the platform acquisition and the "roll-up" strategies. In the first approach, LBO funds acquired or established a platform company from which they would make other consolidating acquisitions in the same industry. This could be particularly effective in situations where only one player was attempting to consolidate a fragmented industry. Where more than one bidder pursued a similar strategy, attractive acquisition candidates were often acquired after a bidding war ensued, and frequently at premium prices. The premium prices were justified because the acquisition "story" assumed a stronger competitive positioning with the ability to impose higher pricing in the marketplace coupled with the future cost savings available from the conglomeration.
A perfect example was the roll-up strategy employed by two competitors in the funeral home business during the 1990s, Lowen Group and Service Corp. Both companies went on aggressive acquisition campaigns, both overpaid for targets, and both achieved negative returns for their debt and equity investors, with Lowen Group forced to file for protection from its creditors in Canada and the United States.
Inference: Acquisition-based growth requires a disciplined use of capital, particularly when an abundance of capital is available. When an industry experiences rapid consolidation, it may foreshadow an industry-wide restructuring.
3. New technologies, such as the Internet, may attract unwarranted amounts of new investment. In December 1999, Amazon.com's stock peaked at $113. By Dec. 31, 2001, Amazon's stock closed at $10.82. Amazon has never been profitable, yet it is one of the better performing Internet stocks and has been able to raise billions of dollars in equity and debt capital.
New technologies, especially when presented as stand-alone investment opportunities, are bound to have exceptionally high failure rates. Many Internet start-ups tried to pretend that business and information processes could be stand-alone enterprises. They failed. Webvan, for example, thought it could do what grocery stores had given up on decades earlier: home delivery of perishable and non-perishable goods at prices competitive with existing supermarkets. But their business model did not envision premium pricing for what was a premium service. Moreover, the convenience for customers—home delivery—was a logistical disaster for Webvan, and they could not get the sales volumes needed to become profitable. Webvan's shortfall does not mean that grocery stores will not be able to offer web-accessed purchasing and delivery. Rather, it infers that these business units cannot be stand-alone low-price competitive independent enterprises. Internet processes are a better means of communication, but not necessarily a better means for delivering tangible goods (as opposed to intangible properties such as software, entertainment and obtaining and transacting in information services).
Inference: Hurdle rates for investing in new technologies should be sufficiently high to compensate for the risk. The mania of the late 1990s, especially for Internet-type investments, all but ignored reasonable and critical evaluations of their business plans and chances for success. When investors become enamored with new technologies coupled with unreasonable valuation parameters, future returns will probably be non-existent.
4. Historical average long-term rates of return do not exceed 20 percent every year. In 1997, 1998 and 1999, the S&P 500 had annual returns of 31.0 percent, 26.7 percent and 19.5 percent respectively, rates that were consistently above long-term historical averages. These returns were aberrations and not sustainable. Long-term average rates of return on debt and equity investments cannot be isolated from the underlying growth of the economy. Annual Gross Domestic Product (GDP) growth of 4-5 percent is a very desirable macroeconomic objective. The North American economy achieving that rate of growth and sustaining it over a long-term horizon would be a remarkable achievement, especially without significant inflation. Higher growth rates without inflation would be even more remarkable. While the two indices are not the same (S&P 500 rates of return reflect equity valuations and GDP measures economic performance), economic performance and growth rates are the major underpinnings supporting equity valuations. Therefore, it is inconceivable how a group of 500 companies can collectively and consistently achieve rates of return 15-25 percent greater than the growth rate in GDP. Clearly such rate differentials could not be sustained over a long period, and investors would eventually be disappointed.
One effect of the S&P 500's high rates of return was the inflow of additional capital seeking to invest in potentially high performing sectors of the economy. The abundance of such capital meeting the law of averages and the law of diminishing returns (see trends 1 and 2 above) would ultimately lead to negative returns for these new investors.
|S&P 500Annual Rates of Return||GDP Annual Percentage Changes|
Inference: Additional investment capital chasing "hot" performing sectors of the economy may not provide long-term rates of return that are significantly above historical norms. If equity rates of return substantially outpace GDP growth for several years, investors should prepare themselves for volatile equity markets and negative returns.
All four macro trends were indicators of the economic reckoning that is clearly upon us. The massive interest rate cuts of the preceding 12 months have not lessened the impact of the economic slowdown, and so far have failed to jump-start the economy. This is principally because the improvident investments of the 1990s resulted in too much capacity that still needs to be properly absorbed and deployed. Compounding this are reluctant lenders and investors who have been burned by their own recent excesses. With their continued reluctance to provide new debt and equity capital, they fuel the economy's sideways propulsion.