By Jim Surowiecki
The Fool Portfolio's recent purchase of AMAZON.COM <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %> highlights one of the curious realities of investing in the U.S. stock market, namely that the standards investors use to evaluate start-ups and companies in emerging industries are often different from those used to evaluate established companies, particularly those in mature industries. That difference, in turn, tells us something important about the impact of U.S. capital markets on the way U.S. companies do business, and helps explain why American investment strategies are more beneficial to young companies creating new businesses than they are to older companies looking to evolve.
Amazon.com is the world's largest online bookseller, and in two years of existence has seen its revenue grow sequentially larger quarter after quarter. While the company confronts very real competition, most notably in the form of BARNES AND NOBLE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BKS)") else Response.Write("(NYSE: BKS)") end if %>, the largest chain-store bookseller and a recent entrant into the online business, Amazon's brand name is already surprisingly well-recognized, and it has been aggressive at allying itself with key players in the online world, including most notably AMERICA ONLINE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %>. At the same time, Amazon's business model, which relies on low inventory levels and a tight relationship with distributors, seems to offer the promise of evading the high returns and loaded remainder tables that have been a problem at many book stores.
Many questions about Amazon's future, of course, remain to be answered. Is brand name a high enough barrier to prevent a flood of new competitors? Will the prodigious growth in the number of users of the Internet continue? Will the problems the book industry faces on the production side have spillover effects into distribution? All of these are certainly relevant in determining what kind of company Amazon will be five or ten years down the line.
What's particularly interesting, though, is that the question "What were Amazon's earnings last quarter?" is not one that seems especially relevant. In the last 12 months, Amazon lost $0.62 a share. It has never shown a profit, and its price/earnings ratio is therefore, as they say, "not applicable." Even the vaunted PEG ratio is of little help in evaluating the company, since it's not clear exactly when Amazon will begin to report earnings. It's possible that many quarters will go by before profits of any magnitude start to appear on the balance sheet.
Were Amazon an established company, of course, this would be a recipe for disaster. In the new worlds of momentum and growth-stock investing, any slowdown in the rate of earnings growth is often taken as an excuse for dumping a stock, while an actual decline in earnings is taken as a sign of impending disaster. The ever-shortening time horizons of most fund managers place a premium on sharp quarter-over-quarter improvement, and encourage companies to spend an inordinate amount of time managing earnings in order to meet expectations.
Companies do this, in no small part, because managers in U.S. corporations place a much higher premium upon increasing shareholder value -- as measured by a company's current stock price -- than do managers in corporations in, for instance, Japan and Germany. An important survey of U.S. and Japanese managers taken in the early 1980s, for example, showed that U.S. managers' second most important goal was "higher stock prices" (return on investment was first), while it was the least important goal for Japanese managers. Given the expansion of the use of stock options as compensation -- which gives managers a direct stake in their companies' stock prices -- and the continued bull market, it seems likely that a similar survey today would find an even more stark difference between the two management styles.
Still, it would be hard to argue with the performance of most U.S. corporations over the past five years, and to the extent that a concern with shareholder value has helped make corporations more efficient and leaner, it has had beneficial effects. On the other hand, U.S. GDP growth remains at historically low levels, even in what has become a relatively benign macroeconomic environment. In addition, it remains unclear how much of the improvement in corporate profitability has been the result of a one-time slashing of payrolls and reduction of overcapacity and how much represents a real and sustainable improvement in these companies' long-term prospects. Finally, and most importantly, the U.S. still finds itself with disturbingly low levels of productivity growth, which in turn has meant that the benefits of this Goldilocks economy have not filtered down to the majority of American workers.
The causes of slow growth and of our productivity woes are enormously complicated. (In fact, even figuring out what the American economy is really doing is an almost unimaginable task, given its size and the difficulty of measuring things like service-sector productivity.) It does seem clear, though, that underinvestment in research and development, in new technology, and in what have been called intangible assets -- most notably worker training -- does work as a long-term drag on a nation's growth rate and on its productivity. It also seems clear that the demand by U.S. capital markets for uninterrupted earnings growth discourages corporate investments that have long-term beneficial effects but that in the short term show up as nothing but expenses.
The U.S. emphasis on shareholder value, then, influences companies away from certain allocations of capital precisely because shareholders use rigid standards of value. As Michael Porter of the Harvard Business School puts it in his work Capital Choices, "The U.S. system is less supportive of investment overall because of its sensitivity to current returns for many established companies... The U.S. system heavily favors acquisitions that involve assets that can be easily valued over internal development projects, that are more difficult to value, and that constitute a drag on current earnings."
In addition, Porter suggests, even the kinds of investment companies make are affected, with a premium placed on investing in physical assets rather than intangible assets that are more difficult to measure.
Two kinds of companies are exempt from this narrow short-term focus, though. The first is the turnaround company. When NOVELL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NOVL)") else Response.Write("(Nasdaq: NOVL)") end if %>, recently reported worse-than-expected earnings for its last quarter, for example, its stock price actually rose slightly, mainly because investors were convinced that new CEO Eric Schmidt was successfully clearing out the old and bringing in the new. For Novell, the development of new technologies and the expansion into the Internet are understood as essential and therefore justifiable, even if they hurt earning in the short term.
The second kind of company for whom earnings are, relatively speaking, irrelevant is, of course, the start-up, and here Amazon is a cardinal example. In evaluating start-ups, investors take into consideration many factors other than earnings. They are more likely to study the industry as a whole, and more likely to look at the company's technological and marketing bases. Most importantly, investors are more likely to look kindly on investment in infrastructure and internal development, because they recognize that this kind of investment is essential to attain market share. You can't become a category killer, you might say, by stinting in the short term.
As a result, the U.S. system for allocating capital tends to do extremely well with companies in emerging industries. The explosion of Silicon Valley, for instance, has to do not simply with the brilliance of venture capital firms like Kleiner, Perkins (which has a large investment in Amazon). It also has to do with the willingness of public investors to be far-sighted in evaluating nascent industries, and with their consequent willingness to emphasize long-term development over the short-term balance sheet.
To be sure, there's a speculative element to the willingness to invest in start-ups, and it's also true that some companies reap unjustified benefits from an overall bullishness about an industry. But in the long run it's evident that the impact of the U.S. system on emerging industries is overwhelmingly beneficial.
The problem, though, is that this same tolerance for long-term investment is much more difficult to find when it comes to investors in more established companies. The great exception, of course, is Warren Buffett, but then it's precisely as an exception that Buffett is heralded. Instead of looking past the earnings number at things like market penetration, investment in research and development, and worker training, there's a tendency to value companies very simply on the basis of earnings growth. And while earnings are obviously important, what this means is that companies find it difficult to do the things that might position them for greater growth down the road.
In other words, the things that we recognize about a company like Amazon -- that it's where it will be a decade from now that really matters, that to become dominant it needs to invest heavily, etc. -- are not things that we recognize as easily about companies like IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %> or GENERAL MOTORS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GM)") else Response.Write("(NYSE: GM)") end if %>. And that, in turn, makes the allocation of capital inside these companies less productive than it might otherwise be. One important lesson that Amazon can teach us, then, is that long-term investing is in the interests not just of investors, but also of corporations and of the country as well.