I write this article in mind for those of you who have your wealth primarily concentrated in broad-based index funds, or have created portfolios that are so totally diversified across sectors and industries that you have taken the Scrooge McDuck approach to investing. Instead of focusing on the success of certain companies to deliver returns, you have chosen to rely upon the general growth of economic activity to build wealth.
When events like the financial crisis, the sequester, Brexit, and so on occur, people pause and wonder: What if the post WWII boom in the global stock market was the result of a perfect tailwind consisting of rebuilding, population growth, global trade advancements, and rapid technology advancements that delivered returns far above what can be expected over the coming twenty to fifty years?
Even if global GDP growth slows down, it does not automatically follow that an investor’s returns must go down. That is because there is one huge countervailing force that must be accounted for: increases in owner earnings that result from technology advancements.
Even if the sales growth of global economic activity slows down, technology gains means that a higher percentage of sales activity sticks to the ribs of the owners. If you only sell 2% more per year instead of a historical rate of 4% per year, the growth in profit margins from 20% to 40% over time can act as a direct offset.
When you owned stock in Coca-Cola back in the 1920s, there were giant fixed molds that would make a glass bottle, and then the syrup had to be inserted and mixed, and then someone had to manually put the lid on, and you’d get about a 8% return on equity from the investment. It was great for the employment of Atlanta, the professional class that arose to direct the growth in production and draw up contracts with the bottlers that weren’t owned in-house, and it rewarded the shareholders immensely because the product was scaling across the country.
Now, the demand for Coca-Cola’s products don’t grow as fast, but there are machines that produces hundreds of cans of coke every few seconds with nearly minimal labor requirements. The returns on equity hover between 27% and 32% over the most recent fifteen year period. Even though the volume growth isn’t what it was during the 1920 through 1985 rapid expansion period, the percentage of Coca-Cola’s sales activity that is attributable to the capital invested by shareholders has increased fourfold.
I am far, far, far, far more concerned with the long-term employment rates in industrialized countries than I am with the returns that the investors in those countries will be able to experience. If Coca-Cola had to use 1920s technology to deliver its beverages to its current locations, it would require 2 to 3 million employees. Instead, there are 125,000 employees, or nearly 200,000 if you count the bottlers in areas where they are independent companies from Coca-Cola.
Not only is the trend in favor of higher owner earnings due to technology gains, but there is also a richer consumer worldwide that can purchase. If you’re a United States reader, your grandparents had a very basic definition of necessities: Food. Utilities. Shelter. Car. Insurance. Somewhere along the line over the past two generations, we have added cable bills, internet, air conditioning, and cell phones. Our bundle of consumer entitlements is perpetually increasing. And even the quality of those entitlements expands: there is a good chance that you eat out more per month than your grandparents did per year.
Population growth, and the increase in GDP, do facilitate investment returns. But if they falter, there are countervailing factors that can still deliver adequate long-term returns even if the special growth factors of the 20th and early 21st centuries don’t continue. Technology gains enable owners to reap more of what is created, and the larger free cash flows are able to fund things like share buybacks at a historically unprecedented rate to give owners a larger percentage ownership share in the businesses. Likewise, if the population growth slows down, this can be offset by a richer typical consumer that purchases more goods and services than the previous generation did.
Consider Exxon from 1985 through 1999 (the eve of its merger with Mobil that would distort our ability to make an apples-to-apples comparison). It only doubled its revenues over those fourteen years. If there were no dividend payments, share buybacks, technology gains, or balance sheet changes, you would expect a dollar invested in 1985 to turn into $2 by 1999.
And yet, a $1 invested into Exxon in 1985 would have become $10.48 in 1999. Well, it usually had a 3% dividend that grew each year. It retired over a third of its outstanding stock in those 14 years. Its technology gains improved the profitability per barrel of oil from 4% to 9%. It did refinance some debt at lower rates, and that factor will not be as prevalent in coming years. And its stock did participate a little bit in the dotcom era excess, such that it was maybe 33% overvalued. If you remove the financing and debt factors, we are still talking about a company doubling revenues and turning $1 invested into over $7 during a fourteen-year period when the revenues alone would suggest a mere doubling of profits if there were no either sources driving investment returns. Well, those other sources would be the difference between doubling and septupling an investment. Dividends, large buybacks, and productivity/technology gains sum up to quite a lot. Don’t forget these important factors if you ever get gloomy about the absolute expectations for population growth, GDP growth, or whatever cumulative factor is focused on in the moment.