"The fundamental impulse that sets and keeps the capitalist engine
in motion comes from new consumers' goods, the new methods of
production or transportation, the new markets, the new forms of
industrial organization that capitalist enterprise creates."
Joseph A. Schumpeter
Capitalism, Socialism, and Democracy
(1942)
There is an exhibit in New York's American Museum of Natural History that chronicles the tree of evolution. If you walk along the path of vertebrate evolution, you might note that the largest land animals of their eras vary in size. There is no final goal to biological evolution, which is caused partly by random genetic variation and then selection by the environment.
Why do things get better? Why do new antibiotics, faster aircraft, and the Internet happen? Unlike biological evolution, corporate and technological evolution can be reasonably directed.
In a book titled "Winning through Innovation," Michael Tushman and Charles O'Reilly (1997) investigate why companies such as Hewlett Packard and General Electric maintain their leadership through numerous product cycles. The most crucial element is a company's values, or vision. The authors write, "While market share, return on investment, and performance against budget are useful and important means for assessing short-term performance, the values and norms that drive behavior, which combined form an organization's culture, are among the most critical factors in determining long-term strategic success. Profits is important, but only if it signals something larger..."
Consider these simple and understandable corporate value statements:
Merck: "We are in the business of preserving and improving human life."
General Electric: "Our behavior is driven by a fundamental core belief:
the desire, and the ability, of an organization to
to continuously learn from any source, anywhere -
and to rapidly convert this learning into action..."
Values enable these companies to be consistent as they implement strategies that cause change. Since companies exist to implement strategies, the authors write, the critical tasks, people, formal organization, and culture should be congruent.
Managers of these companies manage both existing operations and prepare for more radical change. The authors write, "Organizations can sustain their competitive advantage by operating in multiple modes simultaneously - managing for short term efficiency by emphasizing stability and control, as well as for long-term innovation by taking risks and learning by doing...The ability to shape innovation streams hinges on an organization's ability to simultaneously engage in multiple types of innovation."
Tushman and O'Reilly have written a management text. We now discuss the companies they mention as investments. We neither recommend nor discourage investing in the companies mentioned here or in the text at current prices; we own some of the stocks mentioned. In addition to sustainable earnings growth, there are two other investment considerations:
1) Company Valuation. We prefer to buy innovative companies when their P/Es are low. What to do when their P/Es are high?
For the reasons we have discussed, it is not usually a good idea to sell a somewhat overvalued company that you like in order to buy a one that is undervalued solely by quantitative measure. Consider the fact that 12% earnings growth a year compounds to a 25% increase in only two years. This earnings growth is the underlying trend upon which interim price volatility is superimposed. However, if valuations become excessive, extensive sales might be warranted.
2) Market rotation. Many companies with sustainable earnings growth are consumer non-cyclicals, the kind of stocks that do well relative to the market when the economy is slowing down or set to do so. What to do when the economy is speeding up? Investors can consider non-cyclical stocks a core portfolio and then manage around this core by purchasing cyclical stocks or by raising some cash.
Since managements of these companies evolve their product portfolios to produce fairly steady earnings growth, valuation and market rotation are the reasons for selling. Since we invest mainly for the longer term, we consider the latter factors but only to some extent.
Constitutionalism and markets are the two major hallmarks of the liberal system. In 1989, the social scientist Francis Fukuyama wrote, "In watching the flow of events over the past decade or so, it is hard to avoid the feeling that something very fundamental has happened ..." What he announced was nothing less than the permanent victory of the ideas of economic and political liberalism over other systematic alternatives, such as Marxism.
Several commentators took issue with such a broad generalization noting:
1) There cannot be a perfectly just society and therefore a final form of government. (Moynihan)
2) The future is unknowable. (Himmelfarb)
3) Liberal democracies, once established, are stable; but they are difficult to establish. (Sestanovich)
Almost all commentators, however, agreed that there has been a decline in inter-state conflicts and in revolutionary ideologizing. Is the world safe for the Internet? The following article examines the economic dimensions of the liberal world order and the reasons for its growth.
The Enlightenment of the 17th century accelerated a process of continuous change. By its assumption that men could discover the truth of the world through Reason, this international movement resulted in the the discovery of scientific laws, the development of technology, and the growth of commerce. More than two hundred years after Hume's appropriately cautious empiricism, a system of social organization based upon the dispersal of knowledge and co-ordinated by the invisible hand of the market system has proved to be the most efficient. As opposed to other systems, the liberal economic system:
1) Recognizes unique human motivations and conditions, thereby leaving most initiatives local. Diversity leads to innovation.
2) Satisfies demand efficiently, because an open and competitive price system instantaneously reflects the abundance or scarcity of resources utilized by all suppliers.
3) Is consistent at all scales. The idea of liberty under the law pertains to the person, the community, and the nation. Free markets require institutions.
The liberal world order induces rapid economic and social change, catalyzed by commerce. This commerce occurs within a system of trade organized by nation states.
Market economies are examples of evolving open systems, which have correlated processes directed at achieving some general set of values. Consider the Internet, where manufacturers produce ATM equipment which implement protocols developed through Internet Society procedures, for internet service providers, who in turn supply telecommunication services to consumers and other businesses, who... The goals of the Internet might be so stated: to improve communications and to increase GWP.
Closed systems, on the other hand, are mechanistic systems whose behaviors can be totally predicted. Oreskes et al (1994) suggest that in the natural world, closed systems are the exception rather than the rule, "...because only purely formal logical structures...can be shown to represent closed systems." Models are useful as research tools to prompt a better understanding of the world we live in, but models cannot relieve investors of the responsibility to exercise their judgment because investing is about the future.
3. THE NATURE OF STOCK MARKET EXPECTATIONS
Investing is about the present and the future. A company announces a new scientific discovery; is that a basis for investing in its stock? Management announces its fifteenth consecutive quarterly earnings increase. Are these reasons to invest? It depends.
Investing is about the future profits and cash flows that investors expect; yet economics does not say much about these expectations, beyond assuming them to be conveniently uniform. There is much investment literature that characterizes the market as fickle or excessively volatile. However, consider only the macroeconomic variables of current S&P 500 earnings, capacity utilization and inflation (interest rates) one year hence. Our model calculates the following range for the S&P 500.
Calculated Value
S&P 500 11/6/95 = 588 Economic State: S&P500:
Extreme Inflation
and Recession
[caputil = 75%, infl = 10%] 174
Benign
[caputil = 85%, infl = 2%] 930
Without considering the error terms of our model, this analysis shows that for only fundamental reasons, the stock market can vary in a very wide range. It matters whether the macroeconomic environment is benign or problem ridden, as during the OPEC decade of the 1970s. Since macroeconomic conditions weigh so heavily upon expectations, market pricing is primarily about the present and the near term future.
The present and the near future enters into our model of stock market pricing with the following terms:
1) Current S&P 500 earnings, a scaling factor that enables the
stock market to grow with the economy.
2) An estimate of inflation and capacity utilization one year hence.
Markets value most the present and the near future. In the language of economics, investors' expectations are mainly adaptive, and to some degree forward looking. This suggests a standard of care based on the facts when purchasing stocks. If you invest in turnarounds, wait for some evidence of this. If you are investing in a company for its new technology, first see that the company has profitable sales. If a company has been growing, be sure that most of the elements are in place for it to continue to do so.
Are markets influenced by the past? Our model of stock market behavior does not predict the present from the past, but consider the past in a wider sense. The standard economic model consists of self-interested individuals, guided towards the greater welfare of society by Adam Smith's invisible hand. However, as the economist further wrote; a system of competing individuals also requires a common set of values or rules. Invoking the 17th century model, economies and societies require a balance wheel. The U.S. stock market is certainly not a clock, but events usually have their own proportions due to the influence of macroeconomic cycles which are modulated by Federal Reserve policy.