"Kee" Points with Jim Kee, Ph.D.

Last week was a strong one for equities around the world in general, and for the US in particular, with the S&P 500 stock market index up almost 2.5%. Reasons include continued progress toward a third Greek bailout, China’s stock market support efforts, good US economic data, and a decent (so far) earnings season (companies reporting their second quarter earnings or profit/loss numbers). Only 12% of companies have reported, but the majority have beat analysts’ expectations for both sales (i.e. “topline”) and earnings or profits (i.e. “bottom line”). US stocks aren’t anywhere near cheap, but they aren’t anywhere near “bubble” valuation levels either.

 

Following the week-to-week headlines too closely can sometimes get you too caught up in the minutia, so it is often helpful to step back from time-to-time and look at the big picture. The McKinsey Global Institute does a good job of this, and they recently identified several dramatic, long-term global forces at work, including (a) the combination of increased computing power and global connectivity, (b) aging demographics globally and the growing demand for healthcare, and (c) the “age of urbanization” as the world’s rural populations move from the country to the city. These forces are driven in part by dramatic technological advances, which are expected to continue. Google’s Hal Varian (former Berkeley microeconomics guru) has argued that many of the benefits of these rapid technological advances are free and therefore not counted as economic output. Since productivity is output per unit of input, if output isn’t getting captured, then productivity is being understated. That’s a deep topic, and Varian is perhaps overstating his case here to counter the notion that productivity in the US is flat or declining. But there is something to Varian’s assertions.

 

Consistent with the notion that many gains from innovation are free or undercounted, the McKinsey Global Institute asserts that 2/3rds of the gains from new internet offerings (including various applications) are captured by consumers in the form of “consumer surplus.” That’s a term economists use to describe how much of a given innovation is captured by customers in the form of lower prices and increased qualities and quantities of goods and services, rather than by businesses in the form of higher profits.

 

Every business can be conceptualized as performing two functions: value creation, and value appropriation. Value creation activities (often approximated with R&D spending) generate valued products, like copy machines, ceramic engine parts, and web applications like Uber. Value appropriation activities (often approximated with advertising spending) like pricing schemes, brand-building, sales promotion, etc., involve trying to get paid or rewarded for all of that created value. History is full of companies that created a lot of value through innovation but that didn’t necessarily capture the value created in the form of higher profits. Competitors did that, as did consumers in the form of lower prices and better goods and services. In fact, research has shown that once a company comes up with an innovation, it will be more profitable if it switches from R&D spending (value creation) to advertising spending and brand-building (value appropriation). Many CEOs argue that, because intellectual property rights are so poorly protected around the world, a strong brand is more defendable than a strong patent!

 

I mention the above as a reminder that, whether looking at weekly headlines or at broader big picture themes, successful investing results depend upon solid company results, not exciting stories or transient data points. Companies benefiting from positive global forces will show up on our screens by having superior sales and earnings growth rates. Companies investing a lot of capital but with little ability to appropriate the gains will not.