The Glass Ceiling

November 2, 2006

With the Dow breaking its all-time record, now is a good time for an investment sanity check.

While specific areas of the market can march to their own drums for years, broadly speaking, stocks have some natural boundaries for potential upside. When these boundaries are breached, pain and suffering inevitably ensue. Witness 2000 – 2002.

The big story lately is the incredible earnings growth of corporate America. As earnings are the core to long-term stock market returns, this is good news – certainly a better foundation of investment than boundless revenue growth or market share growth or user growth or even that “potential future maybe revenue growth” that was driving stocks a few years ago. 

Double-digit earnings growth year-over-year has been going on since the end of the last recession in 2003. In addition, corporations now earn a record percentage of the total U.S. gross domestic product (GDP).

In other words, companies are growing earnings fast and are improving profit margins – they may earn $1 for every $10 in revenues, as apposed to $0.50 on every dollar in revenues in lower-margin times. 

The trouble is that these companies are about to hit a wall. That wall is U.S. economic growth – or GDP growth. Since it’s not possible for companies to earn much more of GDP (profit margins can’t go to 100%), earnings growth will eventually have to grow at the same rate as the economy. Call it financial physics.

If the economy grows at 3% (adjusting for inflation) and corporate America grows earnings at even 7% (forget 15%) corporate America’s earnings as a percentage of GDP would have to go up – which they simply can’t do for much longer. 

There is one way that earnings growth can exceed GDP growth – grabbing up market share from competitors. Imagine a local pizza place that is run inefficiently and is slowly crushed by Domino’s. As Domino’s takes on that smaller company’s customer base, it can grow. In this way, Domino’s may grow earnings at 10% a year while all the mom and pop pizza places shrink slowly – the net is a 3% GDP growth rate. Trouble is, eventually everything is a giant, publicly traded corporation and you hit the GDP growth wall.

Perhaps our economy will grow a little faster when all businesses are efficiently run, publicly traded corporations. We’ll still never see double-digit GDP growth year after year simply because all the inefficient businesses have been put out of business. Even Wal-Mart’s growth is slowing as they run out of competitors to squash. Besides, publicly traded America already earns the lion’s share of all economy-wide earnings. The big bang consolidation has already happened over the last few decades. It's one of the reasons stocks have performed so well during this timeframe. 

The sobering conclusion is that when corporate America can only grow at maybe 4-5% or so (adjusting for inflation), stock returns will slow and investors won’t pay high valuations for what is essentially a slow-growth business – namely, all business. 

This doesn’t make stocks a bad investment for the long haul. Certainly stocks are more realistically reflecting limited growth going forward than they did in 2000. Still, it does mean that average annual stock market returns over the next 20 years will be in the 5-7% range, not the 9-12% range of history. 

The same logic applies to specific types of stocks. This ceiling was hit at different times by telecom, drugs, software, beverages, etc. (though different growth rates exist for each). This doesn’t mean there can’t be big success stories like Red Bull, Apple’s iPod, Starbucks, or Google, but by and large, the beverage industry as a whole is a slow-growth business. Investors make their worst mistakes when they forget the natural limits of any area and project past growth into the future indefinitely.

REITs (Real Estate Investment Trusts) currently fit the bill for limited future growth. These businesses own apartments, hotels, offices, and stores. The spectacular growth since 2000 is largely because the asset class was so out of favor in the 1990s, when investors were less fascinated by the ultimate brick and mortar business. 

Rental units are commodities. And unlike, say, oil, it’s relatively easy to add more supply over a few years time, especially with so much investor capital dying to do real estate deals. It's just a matter of time before available units exceed demand by enough to send rents downward, taking REITs and real estate-oriented mutual funds (which tend to own REITs) down with them. 

Even if a glut doesn’t form, ultimately rents can’t go up much faster than incomes and earnings (factors that pay rents) without some systematic under-building (if all builders kept supply off the market like OPEC).

We’re already starting to see the result of over-building. New home prices just fell almost 10% from levels hit a year ago – the biggest year-over-year decline in 35 years. This news came just months after the major realtor business association claimed that price declines simply don’t happen in the housing market on a national level.

Some of the best returns going forward will be after mini-crashes that happen when investors realize future earnings growth is not quite so boundless. Some of our biggest gainers in the Powerfund portfolios in recent years have been picking up the pieces after over-hyped areas like utilities and telecom came back to earth. Stick around. We’ll probably be buying REIT funds (again) in a few years after a mini-meltdown.