Is Technology Taking The Economy Nowhere Fast?

By David Karp, PagnatoKarp

“If valuations are similar or higher than past bubble peaks, how can today’s cycle not be considered a bubble?” –Eric Cinnamond (value investor)

If you listen to the financial media, the recurring answer to Eric’s question is in reference to the wave of amazing technology sweeping the globe. Technological advances are the cornerstone to sustainable and durable economic growth. As investors, we must properly evaluate the hype and promise new innovations offer against the cost to acquire them.

Innovation

Think about some recent innovations that have changed the way you live:

• With a click on your smart phone a car appears to take you to your destination. Soon artificial intelligence will make that ride much safer and more time efficient.
• Put on a virtual reality headset and gaze around the Grand Canyon.
• Wear a wristband that tracks your exercise activity, weight and sleep cycles.
• Find dates online without cheesy pickup lines.
• The Internet of Things assures us that houses, cars, appliances and an endless array of systems and devices will collect and exchange data allowing us to monitor and control them remotely.
• And of course, you can shop anytime, at any major store and in some cases receive your goods within hours.

Recent advances in technology save us time, effort, and money but they are doing little to generate sustainable economic growth. Sustainable economic growth is dependent upon sustainable gains in productivity, and domestic and global productivity growth is flat lining despite these innovations. Without consistent productivity growth, corporations must cut labor costs and reduce investments and capital expenditures to increase profitability. In other words, they must continually find new ways to increase their margins.

According to the Conference Board’s most recent annual update for 2016 LINK, total factor productivity (TFP), a broad measure of productivity, shrunk 0.1% in the United States. Declining productivity growth is not just a domestic problem, it is falling in most major economies around the world.

Despite all of the magnificent inventions that make our lives easier, productivity growth in the United States has been trending lower since the 1970’s except for a brief respite around the technology boom of the late 1990s. Despite the trend, the capital markets appear to be pricing in optimism for much greater productivity growth than is actually being revealed by the data above and realized in global economic growth rates.

To better understand why innovations are not as economically influential as many believe, we introduce the work of Clayton Christensen, a professor at the Harvard Business School, best-selling author and co-founder of Clayton Christensen Institute for Disruptive Innovation. Long at the forefront of the study of innovation and productivity, Christensen developed broad innovation attributes that allow us to distinguish among new technologies to better measure their ability to generate economic growth.

The computer is a great example of what Christensen coins a “market-creating or empowering innovation”. Over the past 50+ years, computers progressed from the behemoth ENIAC, which weighed over 30 metric tons, to the desktop/laptop PC and most recently to pocket-able smart phones. Over this period, the number of users and computing power increased exponentially as costs decreased significantly. Inventing and producing market-creating innovations, like the computer, occur over long time horizons and typically involve significant capital investment. The risks of failure are plentiful. Despite the longer time frame, costs and many risks, however, the dividends resulting from such innovations are long lasting. These innovations generate new products, jobs, and create companies and entire industries. One of the more powerful aspects of these innovations is their migration from limited accessibility, as the ENIAC and Cray computers were, to mass production at a reasonable cost like Dell and Apple computers. Needless to say, market-creating and empowering innovations provide durable economic growth and prosperity for decades and even centuries.

“Efficiency innovations” produce economic benefits as well, but they do not multiply upon themselves as do market-creating innovations. Innovations in this group decrease the costs of producing or distributing goods and services, typically by reducing the man hours or resources needed. Self-checkout registers at supermarkets are a good example. These registers do not increase sales, however, they decrease store expenses as fewer employees are needed to sell the same amount of groceries. The benefits of automated registers are predominately cost savings and increased profits. The automated register is an economic benefit resulting from the invention of the computer. However, unlike the computer, automated registers do not create incremental efficiencies beyond the initial gains. They are a “One Trick Pony.”

Efficiency innovations sustain economic growth by producing efficiencies and reducing costs while market-creating innovations produce incremental economic growth through the development of new products, services and industries that subsequently proliferate. When both types of innovations are equally pursued, an economy has the best chance to reach its optimal growth rate. Efficiency innovations reduce the need for labor and other resources resulting in higher profit margins. The additional cash flow and excess labor capacity can then be employed to develop market-creating innovations. When market-creating innovations come to fruition, they create new jobs, businesses and more efficiency innovations.

A balanced approach to these two broad types of innovation is essential to building sustainable economic growth and prosperity. The current short-termist, profits today, behavior among corporations and many investors neglects funding for the longer-term, risky and expensive, market-creating or empowering innovations. Over the last ten years, S&P 500 corporations have returned more money to shareholders via share buybacks and dividends than they have earned, leaving little for investment in their future. Blind to the neglect for longer-term prospects, investors riding a wave of market euphoria have chased prices of financial assets and collectibles to dizzying heights.

Today’s Technology

To further elaborate on the work of Christensen with regard to today’s technology, we examine a few popular companies and their recent innovations.

Facebook (FB) and Google (GOOG), two of the hottest tech stocks in the market, are simply advertising companies. Based on current financial reports, 95% and 88% of revenue from FB and GOOG respectively come from advertising. These companies and others like them are the new Mad Men. They have powerfully harnessed internet technology and data management to enable more efficient direct advertising at lower costs. The stock prices and earnings of companies like FB and GOOG are soaring, but the gains are coming at the expense of the traditional media. In other words, the advertising industry is not expanding, profits are shifting. Further, for decades domestic advertising revenue has hovered around 1% of economic growth (GDP). When evaluating companies in this industry, we must consider that revenue is limited to the amount of market share these companies can garner. These firms are efficiency innovators.

Amazon (AMZN) and Uber are middlemen. They are brokers standing between the suppliers of goods and services and the purchasers of those goods and services. AMZN, Uber and many other middlemen have created a more efficient and cheaper way to make transactions. Like the advertisers, the potential revenue middlemen firms can gain is limited to the size of the industries in which they are involved. As an example, AMZN is growing revenue at a remarkable rate, but that growth is coming at the expense of traditional retailers and malls. These firms too are efficiency innovators.

Companies like Airbnb, DogVacay and Fluid are profiting from millennials’ penchant to borrow as opposed to purchase. Millennials, the quickly rising consumer class demographic, appreciate the economic and environmental benefits of sharing. From cars to residences to tools and machines, a rapidly increasing number of people are benefiting by allowing others to borrow their goods and saving by paying for only what is needed. Firms catering to this new economic paradigm are also efficiency innovators.

There is a large and diversified group of companies with technologies that are potentially game changers. Tesla (TSLA), for instance, has broken into the behemoth automotive industry and almost single-handedly made electric cars popular. In terms of innovation, TSLA has introduced an efficiency to existing automotive technology with broad implications for energy consumption and the environment. However, as good as the technology might appear, can TSLA and electric cars have the market-creating impact that Henry Ford had? Will new industries be born? Will populations shift? We doubt it. However, this is not to say that TSLA and other innovative companies will not be wildly successful but thus far they are not the authors of empowering, market-creating innovations.

Huge leaps in block chain technology, artificial intelligence, 3D printing and genome studies, to name a few modern innovations, offer incredible promise for our economic future. Block chain, for example, is likely to revolutionize database management with enormous potential as an efficiency innovation and possibly a market-creating innovation. Markets will dictate demand for these innovations and ultimately determine whether they are market-creating or efficiency innovations. These less known innovations, unlike the others listed above, may hold the ability to generate real, durable economic growth and propel the economy out of the current productivity stagnation.

Stocks versus the Economy

There are currently, and certainly will be in the future, companies that innovate and make their owners a fortune. Finding these rare gems is difficult but the payoffs are incredible. From a macro perspective and as an investor in a broad portfolio of assets, we must consider the economic influence that innovations can have. In other words, what can Google, Amazon or Tesla do for productivity growth and the economy, not just for their shareholders?

Investors must contemplate whether the current technology wave justifies the historical valuations bestowed on those leading the innovation charge and those other companies along for the ride. Said differently, are valuations of most major indexes surpassing prior peaks because we are witnessing the birth of the next car, computer, or railroad? Time will tell.

To help answer the question we quote guidance from Christiansen:

In an interview with Forbes in 2012 Christensen had this to say about efficiency innovations: “Our current economy, however, has gone off of the rails in large part because we are focused almost entirely on efficiency innovations—on streamlining and wringing bottom line savings and additional profits out of our existing organizations.”

A year later he followed it up with this from an interview in Inc. magazine: “My sense is over the last 20 years the American economy has generated about one-third the number of empowering innovations as was historically the case,” he said. What’s the potential toll of all this lost innovation on the future of the country? Christensen hypothesized: “If you want to know what the future of America looks like, just look at Japan. You can feel the same thing happen in the United States, and I worry a lot about that.”

Summary

This current period is reminiscent of the 1990’s, the “this time it is different” era. The birth of the internet was promising as was the prospect for superior economic growth. Despite the new paradigm, and “cool” innovations, valuations regressed to historical averages. From 2000 to 2002, the technology laden NASDAQ index fell 83% while the other major indices, which were largely representative of non-tech companies, fell markedly as well.

History is littered with periods where hope trumped reality and the next great wave of technology proved less economically beneficial than expected. We suspect that today’s soaring valuations and forecasts for earnings growth will meet a similar fate but for prudent and patient investors, therein lies the opportunity.

Productivity is the key to economic growth. If we go back to the saving and investment behaviors and longer term outlooks that fostered the great industry-generating innovations of the 19th and 20th centuries, we can contend with the troublesome debt burden and unleash a wave of economic growth, creative ingenuity and prosperity that the nation desperately needs.

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At PagnatoKarp, the goal of our True Fiduciary? Standards and Fiduciary Family Office? is to focus on safety of assets, lowering costs, and simplifying your life so you have more time to spend on what matters to you most. Contact us at www.pagnatokarp.com or 703-468-2700.

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