Where Will the Growth Come From?
One of my most significant learning experiences came from a basic forecasting mistake. Back in 1998, I looked at 40 years of documented evidence that 50% of all large programming projects ended up coming in late. That set of data was consistent over all industries and over decades. I checked it out with industry experts. I really did my homework. And thus I said that the Y2K bug would be a problem, as a sufficient number of corporations around the world would have bugs that would create supply and management problems, which would slow the economy down. I did not suggest that we would see blackouts or major problems, just enough to slow things down and, when coupled with other macro issues (like the tech bubble), could trigger a recession. We had the recession, so my investment advice actually turned out to be right (lucky?), but it was not caused by Y2K.
Almost 100% of the Y2K fixes came in on time. From a metric that said 50% was the norm, we went straight to 100%. What caused the change? I had a debate with (my good friend) the late Harry Browne, who many of you will remember as a very wise investment counselor, multi-book best-selling author, two-time presidential nominee of the Libertarian Party, gold bug, and from the school of Austrian economics. He said that Y2K would be a non-event. When presented with my marshaled facts, he said, "John, each company will figure out what it has to do to survive. That is the way markets work." And sure enough, faced with extinction if they failed, it seems that CEOs found ways to get the programmers to meet a very clear deadline. Besides knowing they fudged deadlines in the past, we now know if you hold a gun to their heads and give them resources, they can in fact perform.
Why this comment to open today's Outside the Box? Today we read a piece sent to me by my friend Louis Gave of GaveKal (and who will be at my conference in April). It is entitled "Where Will the Growth Come From?" It reminds us of the lessons that Harry gave me. Each person and company is responsible for their own part of the recovery. You can't rely on mass statistics, or you miss the important lesson in individual responsibility.
I don't think anyone can accuse me of being bullish the past few years. Interestingly, I get a lot of emails from people telling me the end of the world is coming, and deriding my longer-term optimism. They are convinced we are going into some deep national morass worse than the Great Depression (and such deflationary times will somehow make their gold go to $3,000!?!?). Yet they are working to make sure their own personal worlds are covered. I get no letters from people who are simply giving up. What company will keep a CEO who does not work hard to figure out how to keep the company alive? If you lose your job, do you not try and get another one or figure out how to make ends meet? Do you not put in extra hours to try and make your personal life or business or job better? Even if it is terribly difficult, the very large majority of people don't throw in the towel. Each of us, in our own way, gets up every morning to fight the good fight, even when the swamp is full of more alligators than we ever counted on. We just pick up a baseball bat, wade into the swamp, kill as many alligators as we can in one day, and then go home to get ready to fight the next day.
The lesson from Harry is the same as it was in 1998: It is the individual working to get his or her own house in order that will help us all collectively get our national house in order. This is not to diminish the Herculean tasks we have in front of us, collectively. We have dug ourselves into a very deep hole of credit and leverage. It is going to take lots of time. The way back is not entirely clear at this point. This is not an ordinary business-cycle recession. But each of us will do what we can to make our small corner of the world better. And in the fullness of time, we will collectively get back to trend growth and a rational market.
Of course, we will then find we have other problems to face. There is no nirvana. There will always be more problems. But that's what a free-market collection of motivated individuals does: We face problems and solve them to the best of our ability. And as a group, the clear path for centuries is one of growth and progress. Cautious optimism is the proper long-term stance.
So, today Louis speculates about what sectors might come back first, and offers a good lesson in economics along the way. I think you will enjoy this Outside the Box, unless you just want to believe in the end of the world.
John Mauldin, Editor
Outside the Box
Where Will the Growth Come From?
by Louis Gave
In a book written in 2005 and entitled Our Brave New World (now out of print but available for free download from our website), we argued that the defining feature of the global economy was overcapacity. Back then, it was hard to fully appreciate the overcapacity that existed in the world, and in the subsequent years, we can not remember how many debates we had with clients trying to dispel the notion that the world was going through simultaneous "peak oil", "peak copper", "peak wheat", etc. One of the pillars of our case was that what was masquerading as consumption was really investment; global growth dynamics were running full steam, and OECD manufacturing capacity was very quickly being replaced by ASEAN capacity. Fast forward to today, and with production now collapsing at unprecedented rates around the world, the overcapacity to produce everything is now blindingly obvious. In the race to the bottom:
- The International Labor Office recently warned in its annual report that 51 million jobs are likely to disappear by the end of 2009 as a result of the economic slowdown, pushing the global unemployment rate to 6.5% by the end of the year.
- The IMF warned that global growth would slow to 0.5% this year, well below the 2.5% typically used to define a global recession.
We could go on but our readers know the dismal stats by heart. Everywhere one cares to turn to, one finds recession, and a grim economic outlook and nowhere more so than in the US where overcapacity is manifest in falling capacity utilization and declining employment. We combine these variables in what we call Economic Utilization (which is just capacity utilization minus unemployment) and compare that to the OECD's output gap measure for the US. As the chart below makes clear, given the continued rise in the unemployment rate and drop in and capacity utilization, predicting a much deeper drop in the output gap is not really heroic:
Most investors have a natural tendency to project their most recent experiences far out in the future. Thus, we probably should not be surprised that the question on everyone's lips today is "where will the growth come from". And undeniably, answers to that question are hard to find - which means that we should probably go "back to basics" in a bid to identify the winners of the next cycle.
1- A Quick Theoretical Primer on Different Growth Models
In his Law of Eponymy, statistician Stephen Stigler wrote that "no scientific discovery is named for its original discoverer". As far as we can tell, this is definitely true of economics!
Take the notion of "comparative advantages" as an example. It was first introduced by Robert Torrens in 1815 in Essays on the External Corn Trade but it was David Ricardo who formalized the idea in On the Principles of Political Economy and Taxation in 1817. And the idea, like all good economics idea, was simple enough: Ricardo showed conclusively that a country can gain from trade even if it is technologically inferior in producing every good. Instead, a country is said to have a comparative advantage in the production of a certain good if it can produce that good at a lower opportunity cost than any other country. And by introducing this notion of relative opportunity cost, Ricardo identified the first potential source of growth for an economy: the rational reorganization of production that results when an economy moves form a state of autarky to one where trade becomes the norm, whether through better infrastructure, lower barriers, less regulations etc... In our research we have called such impetus the "Ricardian growth".
Or take the notion of "creative destruction" which we all associate with Joseph Schumpeter's explanations that it is the entrepreneur's job to break out of the steady-state circular flow of the economy and develop new methods, techniques, and products and which, as highlighted in Our Brave New World (calling it Schumpeterian growth), is the second pillar on which economic growth rests. That notion was actually first developed by Johann Heinrich von Thunen who transformed the incomplete marginalism of classical Ricardian theory into comprehensive neoclassical marginal productivity. Indeed, Ricardo assumed that there was only a single factor of production -- labor. But this does not account for improvements in capital, nor for a deepening of the capital base. Thunen was the first to treat labor and capital symmetrically, showing that each is subject to diminishing returns and that labor's marginal productivity is an increasing function of the quantity of capital per worker. Thunen's work on capital deepening and the resulting productivity addressed the chief shortcoming of the mistaken Malthusian and Ricardian prophecies of doom.
In his book Isolated State, Thunen also wrote the first algebraic production function -- a set of recipes or techniques for combining inputs to produce output. His original algebraic production function, it turns out, is basically the same as the well known Cobb-Douglas production function, created in 1927 by University of Chicago economist Paul Douglas and Amherst mathematics professor Charles Cobb. And further confirming Stigler's rule, Robert Solow also built on the work of the Cobb-Douglas duo, creating the Solow Growth Model, for which he won the Nobel prize in 1990. The Solow Growth Model is the most modern and simple algebraic production function one can use to illustrate the different foundations for growth. The equation is simply:
q = Ak.5, where:
q = output per worker
A = multifactor productivity
k = capital per worker
This equation gives us a simple tool to illustrate economic growth based on capital accumulation, productivity, or some combination of the both. In other words, it helps us understand the constraints on growth offered by Ricardo and the opportunities for growth offered by Schumpeter.
2- The Concrete Use of Multi-Factor Productivity
Consider, in our first example, a country like China that has recently moved out a state of autarky and is saving, and accumulating capital, furiously. For illustration sake, let us say that China is not yet generating multi-factor productivity (MFP) as it is still figuring out how to organize its enterprises and is still learning how to use its capital efficiently. Still, despite the lack of MFP, China's output is still growing at a very rapid pace due to the low starting point and a rapid accumulation of capital financed by a very high savings rates (25% in our example). But, in due course, rapid growth rates slow and, within twelve periods, output per worker grinds to a halt, resulting in the stationary state that Ricardo predicted. From that point onwards, growth becomes solely a function of workforce growth, i.e.: demographics.
Now, let us consider a second example of a country like the United States with a lower rate of capital accumulation, say 15%, but MFP of 1%. In such a case, output very quickly falls, but it never falls to zero. For as long as the US maintains a MFP rate of 1%, output per worker -- or labor productivity -- remains at 2%. Combined with a small incremental growth of the workforce of say 1%, the US can thus maintain 3% GDP ad infinitum.
From the above two examples it is easy to understand:
- Why the growth dynamics of countries like China (or other emerging markets) are so different from those of mature economies like the US or Europe.
- Why productivity growth is so important for a country to achieve as it opens the door to endless growth and wealth creation.
- Why emerging economies need to have high savings rates, while developed economies need to have sustained productivity.
While the Solow growth model is designed to take a macro-economic perspective looking at countries, it is easy to translate the ideas into micro-economic terms looking at companies. Companies generating sustainable productivity growth have, in theory, limitless growth as the continuous achievement of multifactor productivity allows for infinite capital accumulation, output and wealth creation. And this brings us back to the pet theory that ran through Our Brave New World, namely the fact that a new business model has emerged (in our book, we called it the "platform-company" business model) whereby companies increasingly focus on the processes in which they have the most value-added and outsource the rest.
3- The Emergence of Platform Companies
Our work on platform companies has led us to some simple conclusions that we will briefly reiterate:
- Platform-companies have fractionalized their production process, keeping knowledge intensive activities like design and distribution in-house, while outsourcing low-value added physical production. For those companies that still have significant manufacturing assets, they are devoted to complex processes or products, where knowledge is embedded in the fixed capital.
- Platform-companies have worked furiously to develop new products, new markets, and new products for new markets. The US in particular has been very aggressive about investing in foreign countries. Foreign direct investment accounts for some 10% of total nonfinancial corporate assets and generates some $4.7 trillion a year in sales and some $700 billion a year in earnings.
- Platform-companies have piled up huge cash hoards as they optimize supply chains and monetize productivity. Due to the backward tax laws, US multinationals have hundreds of billions of dollars stored up in overseas bank accounts. It is estimated that the nine largest US pharmaceutical companies alone have $113 billion stashed abroad. US companies have so much money squirreled away that Allen Sinai of Decision Economics concluded that, if the US lowered tax rates temporarily on repatriated earnings, companies would repatriate US$545 billion. There is a precedent for this: we saw US companies bring home $360 billion in 2004 as a result of the temporary 5% tax rate contained in the American Jobs Creation Act.
The net result of all this is that platform companies are productivity passthrough vehicles that monetize the continuous evolution of the global production possibility frontier. In other words, platform companies are the beneficiaries of both Ricardian and Schumpeterian growth.
4- Platform Companies & the Financial Crisis
As everyone knows, one feature of the current financial crisis has been a complete evaporation in trade finance. Letters of credit to secure shipping have become hard to come by and local producers have suddenly found it challenging to secure financing from local banks. And while this is undeniably a consequence of the global credit crunch, it is also a side-effect of the overcapacity discussed above. In the current environment, no one wants to take the risk of a ship full of rapidly depreciating widgets making their way from Shenzhen to Long Beach. As a result of these new trends, the Institute for International Finance, a Washington association of international financial firms, estimates that private capital flows to emerging markets will tumble over 60% in 2009 to $165 billion, further exacerbating the global squeeze.
Undeniably this new landscape presents both challenges and opportunities for astute platform companies and the question now has to be how platform companies navigate, and thrive, in this tricky environment? As we see it, there is tremendous opportunity for platform companies to take advantage of the dislocations now prevalent in the global economy. These companies can further their aspirations through any of Peter Drucker's three conditions for success:
- Businesses Can Improve. A good example here would be IBM, who, faced with the current highly challenging environment, has chosen to make its current offerings more efficient rather than embark on the more costly endeavor of developing something entirely new. In recent months, IBM has found a number of new uses for old software that was originally designed to help casinos apprehend card counters; now, with minor modifications, the same software is used to monitor immigration in both the US and UK. Another system, developed to mitigate traffic congestion in Stockholm, has been adapted to function in London and Singapore. In a similar fashion (pardon the pun), American Eagle has taken steps to trim 4-8% from its pergarment manufacturing costs by moving its production from Chinese factories to cheaper labor markets in Southeast Asia. And with the collapse in transportation costs, some embroidering and bead work will further move to India to help cut costs.
- Businesses Can Expand. The decision to expand into new markets also presents significant prospects for companies like Wal-Mart, Coca-Cola, Inditex, H&M, Fast Retailing and many others. Wal-Mart (not to mention other retailers) is on a rather aggressive expansion schedule in international markets, with plans to add more square footage abroad in the next year than in the U.S. With a new, internationally-focused CEO, Wal-Mart plans to add 80-90 new stores in Brazil as well as continue expansion in second-tier Chinese cities (the company already has 217 retail units in China) in an effort to boost its international sales, which currently account for about 24% of its total sales. Coca-Cola is yet another example of a business that is surviving in spite of the downturn. In Russia, for example, the company's impressive distribution system stocks some 480,000 stores -- a critical asset in a time where many distributors are unable to secure credit in order to deliver goods. And, to take advantage of falling advertising rates across the country, Coke has opted to maintain its ad budget in the hopes of increasing its market share. Then there is Inditex, Fast Retailing and H&M -- all apparel retailers planning to continue growing, each opening hundreds of new stores from Cairo to Beijing to Singapore in order to take advantage of the current, rather favorable, leasing terms.
- Businesses Can Innovate. Finally, platform companies can choose to innovate their way to achievement. Both Cisco and SAP appear ready to delve into the world of cloud-computing and software as a service. Cisco's potential foray into the computer market have spurred discussion of the commoditization of computers and networking. In its response to the economic slump, SAP has plans to allow users to pay for and use specific pieces of the product, rather than an entire system. As large, maturing tech companies, Cisco and SAP are seeking other avenues of growth; this volumemonetizer, platform company-esque strategy highlights the increasing importance of cloud computing. In a similar vein, Siemens plans to offer lowcost products -- simpler versions of goods, based on the same technology as their high-tech counterparts -- in the hopes of capitalizing on faster growing markets such as China and India. Capitalizing on Clayton Christensen's concept of low-end disruptive innovation, it can't hurt to sell those same lower-cost products in newly budget-conscious developed markets, too; when the production costs are kept low by manufacturing them in countries where labor is relatively cheap, margins can look the same as those of more sophisticated designs.
In a combination of each of these three attributes, we are hearing rumblings that a large, U.S. multinational household retailer, started last week to offer guarantees and financing to its Chinese manufacturers, in exchange for heavy discounts on current finished inventories and future production. Additionally, this company is actively buying inventories from bankrupt firms at deep discounts. Far from being deterred by today's extraordinary circumstances, the company is seizing the opportunity to improve its procurement efficiency, strengthen its supply chain, advance its open innovation, and possibly gain a better foothold in the local market.
The platform model came to the fore a little over a decade ago as: 1) information and communications prices plummeted, 2) global trade soared and 3) global capital flows surged. This convergence of factors enabled emerging economies to specialize, accumulate capital, and establish new comparative advantages, leading to a dramatic increase in the efficiency of global production. This process also triggered an accelerating pace of creative destruction among the world's developed countries, raising the stakes on the achievement of multi-factor productivity.
The current financial crisis is the first real test of the twin Ricardian and Schumpeterian growth dynamics that gave rise to the platform business model and the growth trends that we have witnessed in recent years. And today, most of our clients seem to believe that the crisis actually marks the death-knell of the model; the coming years are bound to be marked by growing protectionism, collapsing productivity and consequent economic misery.
We disagree and instead believe that recent evidence suggests that, far from being the beginning of the end for the platform-company model, we are simply going through the end of the beginning. With every day that goes by bringing another spate of earnings disappointments, bankruptcies, and examples of mismanagement, it would seem intuitive to expect corporate behavior to reflect these grim times, with companies retreating, retrenching, and regressing. But, in recent weeks, we have started to pick up on examples of the exact opposite, as the well-capitalized platform companies have used this period of turbulence to position themselves for the next phase of growth.
Our bet is thus that the platform model itself will emerge stronger from the current crisis, and play a larger role in future global economic development than most investors currently believe. Globalization is far from dead and the companies that are positioning themselves today to reap its rewards will be the winners of tomorrow.