Buy High Sell Low Macro Trends and Inferences

Wall Street and Main Street: Two mutually dependent, yet often opposing, forces. What
Wall Street sells, Main Street buys—more often to Main Street's long-term benefit but
sometimes to its peril. In part, the result depends on the business cycle and the
state of the economy. And, in part, it depends on the "story" or the investment
thesis supporting the particular debt or equity security. Between the "story" and the
business cycle's phase lie macro trends that can illuminate how specific investments may
perform and, perhaps more importantly, where the economy or sectors of the economy
may be heading.

Macro Trends

1. Capital markets provide more financing than necessary. When it comes to selling
money, Wall Street and financial markets tend to reward innovation and new ideas.
Entrepreneurs, having reaped the rewards of successfully developing a new business,
find their wake littered with financiers eager to offer imitators bigger and better
financing packages. History has shown that financial markets are willing to finance
(and customers are eager to embrace) second and third-tier competitors—the former are
financed for the investment opportunity and the latter for the potential to reduce and
bid away monopoly profits. As new competitors enter the marketplace, overall
profitability decreases and the potential for meaningful returns diminishes (unless new
entrants have advantages such as geographic or governmental monopolies).

Think of hamburgers. In the mid-1950s, McDonald's introduced the revolutionary
concept of fast food dining. Over the next 40+ years, the convenience of fast-food
hamburgers mushroomed into a multi-billion dollar industry, with McDonald's, Burger
King and Wendy's emerging as the industry leaders. When these companies were
established, they fulfilled an important consumer need. Subsequently, with increasing
consumer demand and available financing, these three national competitors (along with
dozens of other non-hamburger chains) became fixtures of everyday life. However, the
increasing competition reduced growth rates and curtailed profitability to the point where
an investor today would be hard-pressed to fund a new fast-food chain with any
expectation of mirroring the returns early McDonald's investors achieved.

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New technologies, especially when presented as stand-alone investment opportunities, are bound
to have exceptionally high failure rates.

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Think of telecommunications. During the 1990s, investors, encouraged by new
technologies and the apparent insatiable demand for communication services (with Wall
Street's assistance), provided enough capital to fund every seemingly reasonable telecom
project. The growth assumptions underlying Wall Street's capital-raising activities seemed
to assure that each project would mirror the early successes of MCI and Sprint,
AT&T's first major competitors.

However, investors missed the bigger picture. In financing the telecom industry
throughout the 1990s, investors failed to grasp the macro environment where the
total capacity under development or construction was so great that it would not be used
for years. A critical industry analysis would have considered the following: How many
different telecom services were needed? How many new telecom services and telephone
lines would businesses and individuals utilize? What new services and price points would
encourage consumers to change over to new competitors? And how would existing telecom
providers react? But the "story" preferred by Wall Street, telecom issuers and even
investors was the micro vision of success without incorporating the macro scrutiny
indicating excess capacity and ephemeral profitability.

Inference: Immoderate access to capital often results in unwarranted investments
leading to inferior or even negative returns, especially when the excess capital is
focused in a specific industry. When this occurs, it usually is measurable and may
be a strong indicator of declining future profitability.

2. Capital markets finance improvident acquisitions. The success of private equity
LBO investments throughout much of the 1980s, with long-term rates of return in
excess of 20 percent, created billions of dollars of available capital for the LBO
progeny of the 1990s, and with it increasing competition for acquisition candidates.
In order to achieve a competitive advantage, many private equity firms adopted a
series of acquisition strategies, including the platform acquisition and the "roll-up"
strategies. In the first approach, LBO funds acquired or established a platform
company from which they would make other consolidating acquisitions in the same
industry. This could be particularly effective in situations where only one player was
attempting to consolidate a fragmented industry. Where more than one bidder pursued a
similar strategy, attractive acquisition candidates were often acquired after a bidding
war ensued, and frequently at premium prices. The premium prices were justified because
the acquisition "story" assumed a stronger competitive positioning with the ability to
impose higher pricing in the marketplace coupled with the future cost savings available
from the conglomeration.

A perfect example was the roll-up strategy employed by two competitors in the
funeral home business during the 1990s, Lowen Group and Service Corp. Both
companies went on aggressive acquisition campaigns, both overpaid for targets, and both
achieved negative returns for their debt and equity investors, with Lowen Group forced
to file for protection from its creditors in Canada and the United States.

Inference: Acquisition-based growth requires a disciplined use of capital,
particularly when an abundance of capital is available. When an industry experiences
rapid consolidation, it may foreshadow an industry-wide restructuring.

3. New technologies, such as the Internet, may attract unwarranted amounts of
new investment. In December 1999, Amazon.com's stock peaked at $113. By
Dec. 31, 2001, Amazon's stock closed at $10.82. Amazon has never been
profitable, yet it is one of the better performing Internet stocks and has been able
to raise billions of dollars in equity and debt capital.

New technologies, especially when presented as stand-alone investment opportunities,
are bound to have exceptionally high failure rates. Many Internet start-ups tried to
pretend that business and information processes could be stand-alone enterprises. They
failed. Webvan, for example, thought it could do what grocery stores had given up on
decades earlier: home delivery of perishable and non-perishable goods at prices competitive
with existing supermarkets. But their business model did not envision premium pricing
for what was a premium service. Moreover, the convenience for customers—home delivery—was
a logistical disaster for Webvan, and they could not get the sales volumes needed to
become profitable. Webvan's shortfall does not mean that grocery stores will not be able
to offer web-accessed purchasing and delivery. Rather, it infers that these business
units cannot be stand-alone low-price competitive independent enterprises. Internet
processes are a better means of communication, but not necessarily a better means for
delivering tangible goods (as opposed to intangible properties such as software,
entertainment and obtaining and transacting in information services).

Inference: Hurdle rates for investing in new technologies should be sufficiently
high to compensate for the risk. The mania of the late 1990s, especially for
Internet-type investments, all but ignored reasonable and critical evaluations of their
business plans and chances for success. When investors become enamored with new
technologies coupled with unreasonable valuation parameters, future returns will probably
be non-existent.

4. Historical average long-term rates of return do not exceed 20 percent every
year. In 1997, 1998 and 1999, the S&P 500 had annual returns of
31.0 percent, 26.7 percent and 19.5 percent respectively, rates that were
consistently above long-term historical averages. These returns were aberrations and not
sustainable. Long-term average rates of return on debt and equity investments cannot
be isolated from the underlying growth of the economy. Annual Gross Domestic Product
(GDP) growth of 4-5 percent is a very desirable macroeconomic objective. The
North American economy achieving that rate of growth and sustaining it over a
long-term horizon would be a remarkable achievement, especially without significant
inflation. Higher growth rates without inflation would be even more remarkable. While
the two indices are not the same (S&P 500 rates of return reflect equity
valuations and GDP measures economic performance), economic performance and growth rates
are the major underpinnings supporting equity valuations. Therefore, it is inconceivable
how a group of 500 companies can collectively and consistently achieve rates of
return 15-25 percent greater than the growth rate in GDP. Clearly such rate
differentials could not be sustained over a long period, and investors would eventually
be disappointed.

One effect of the S&P 500's high rates of return was the inflow of additional
capital seeking to invest in potentially high performing sectors of the economy. The
abundance of such capital meeting the law of averages and the law of diminishing
returns (see trends 1 and 2 above) would ultimately lead to negative returns for
these new investors.

Inference: Additional investment capital chasing "hot" performing sectors of the
economy may not provide long-term rates of return that are significantly above
historical norms. If equity rates of return substantially outpace GDP growth for
several years, investors should prepare themselves for volatile equity markets and
negative returns.

Conclusion

All four macro trends were indicators of the economic reckoning that is clearly
upon us. The massive interest rate cuts of the preceding 12 months have not
lessened the impact of the economic slowdown, and so far have failed to
jump-start the economy. This is principally because the improvident investments of
the 1990s resulted in too much capacity that still needs to be properly
absorbed and deployed. Compounding this are reluctant lenders and investors who
have been burned by their own recent excesses. With their continued reluctance to
provide new debt and equity capital, they fuel the economy's sideways propulsion.

Footnotes

¹ Thanks to my colleague and ABI member Michael Fine for his assistance. Return to article