 Esperanto and the Internet
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By Scott
Lummer
Chief Investment Officer, mPower
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This week's question is related to a column that I wrote
two weeks ago, called "Survivor."
You said that investors should not expect really high
(20 percent or more) returns on stocks in the future. But then why did the market go up by
so much in the past few years?
First of all, short-term historical returns are not good
predictors of future performance. But just for fun, let's look at the current market
environment to explain why I said investors shouldn't expect returns of 20 percent or
more.
Right now the Dow Jones Industrial Average is at 10,600.
Over the past five years, stocks have earned 29 percent per year. Five years ago, given
the economic conditions prevalent at that time, it might have been reasonable to expect a
13 percent return going forward. Earning a 29 percent (compared to a 13 percent) return,
over a five year period, added almost 100 percent of new value to the stock market. In
other words, if stocks had earned "historically" normal returns over the past
five years, stocks would have only about half of their current value.
What recent economic forces have caused stocks to double
their historically normal value? To begin with, all of the basic factors that we typically
consider good for economic prosperity have been in place. Low inflation, low interest
rates, low unemployment, a steady currency, controlled government spending, and general
political stability in the world are all contributing factors. But, my belief is that you,
right now, are using the major contributing factor to the market's current valuations: the
Internet.
There is a problem with an analysis that credits the
Internet with creating value. When people hear this, they immediately start thinking of
Cisco, Oracle, and Microsoft. But, the main impact the Internet has had on stock-market
values has been through companies in the so-called "old economy." The use of the
Internet has dramatically impacted both corporate profitability and growth rates, which
are the two major components that determine the value of a business or an economy. This
has mainly occurred through increases in efficiency.
To give an example of how the Internet has affected
efficiency, consider how quickly corporations have utilized the Internet. Ten years ago,
only a handful of companies had Web capabilities (companies that had e-mail used it
internally). Today, literally every firm — large or small — has a home page and
communicates with outside parties through e-mail. Why do you think companies reacted so
fast in utilizing this technology? Because they saw it as a key method of increasing sales
and improving efficiency.
This lightening-speed adoption of a new technology is
unprecedented in corporate America, in which businesses seldom rush to embrace new ideas.
About 30 years ago, as economic globalization was taking
place, there was a movement to increase foreign-language education in the workplace. And
yet, the vast majority of American's still only speak English. There was also a movement
by some intellectuals to develop a truly global language, called Esperanto. One of the
movement's leading spokesmen was William Shatner. Businesses would have been a logical
place to foster this effort, yet they completely ignored the idea. And now, Bill's legacy
is to be known as a bad singer on commercials, in addition to being a sci-fi TV legend.
Ideas usually take awhile to become established in
corporate America. Nearly every business today is dependent on copy machines, voice mail,
and cell phones. Yet, use of these technologies took a much longer time to become adopted
than did the Internet.
We can illustrate the impact of efficiency on value.
Imagine a sleepy retail company with slow-growth potential and a profit margin of 5
percent (meaning total costs are 95 percent of sales). Now, suppose that the company
adopts the Internet to help sell goods, and in doing so improves efficiency by only 1
percent (the typical ways to improve efficiency are through better deployment of
personnel, more targeted advertising, and better inventory management).
What impact does that 1 percent increase in efficiency have
on value? A lot. This company will now have a 6 percent profit margin, which means
earnings will be 20 percent higher going forward. And, that will translate directly to an
immediate 20 percent increase in value. To say nothing about the potential increase in
sales resulting from the ability to reach potential customers in new ways.
Is the 1 percent increase in efficiency realistic? I can
offer an example from an industry that I know well: the investment-advising business.
mPower's main business activity is delivering investment
advice en masse to our clients' participants in 401(k) plans. Before we started five years
ago, the only companies giving investment advice to 401(k) participants were charging
about $600 per person. We have many highly trained analysts here at mPower, but we are
able to leverage their work across millions of individual clients without needing
face-to-face contact. Our costs per participant in delivering investment advice is under
$60. That's a 90 percent increase in efficiency!
When stock analysts see an increase in profitability, they
analyze several factors to see whether or not these improvements in efficiency, and
therefore profitability, will continue. Increases in general market value do not solely
result from improvements in efficiency over the past five years, however. They also stem
from projected increases in efficiency going forward. And, these increases in efficiency
cause additional economic growth, because businesses that could not have previously
operated profitably can now be started (mPower is an example).
Do all of these factors add up to a consistent doubling of
value? It's really hard to say. But, it's certainly a possibility.
The main point is: I don't believe the market is currently
overvalued. Indeed, some companies may be overvalued (don't ask me for their names, I'll
merely give you a list of our competitors), but not the market as a whole. With the
Internet, we have witnessed a cultural and commercial phenomenon not seen since the
technological boom of the 1950s. It's natural for this development to impact the stock
market.
When 22nd century histories focus on our era, they won't be
writing about Regis, Monica, or Elian — they will be focused on the way you and I are
communicating right now.
Now go ahead, send me an angry e-mail. You will be creating
value.
 Lummer's Logic Archives
The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
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