Saturday, September 12th was a particularly disappointing day for college football fans of Notre Dame and Ohio State, as each team lost to an arch rival on a last second play. Both the Fighting Irish and the Buckeyes controlled play for most of the game, but when the momentum changed it became a different ball game, and neither could stop it.
The markets are also prone to momentum swings which are difficult to stop once they occur. That is the reason I've tried to follow this rule - "It is always better to buy and sell early, than to buy and sell late."
With that in mind, we recently turned a bit cautious on the overall market and have reduced our overall exposure to stocks. In this version of Willingdon Views I will try to provide support for this strategic move from a quantifiable perspective, without any political commentary. I said I will try...
Notwithstanding the myriad of concerns we read about each day, from nuclear weapons development in Iran to mounting federal deficits at home, the S&P 500 has had quite a rally, appreciating about 57% from the March bottom. During this six-month period, the Price/Earnings ratio jumped from 10.6 to 19.5. This is the largest percentage increase in the P/E ratio in over 25 years. Let me try to put that in perspective. First of all, back in March the mood in the market was one of extreme pessimism, as reflected by the consumer confidence index which hit an all-time low going back more than 30 years. Beyond that, many were fearful that the financial system was on the verge of collapse, and not surprisingly, consumer spending grounded to a halt. Within the never-ending emotional pendulum between fear and greed, the March environment was as far to the fear side as we have witnessed in a generation.
Today it is a different ball game... Our financial system has survived. The economy seems to be improving slowly, but steadily, and consumer spending appears to be bottoming. Momentum has clearly swung away from the extreme pessimism evident earlier this year. All of which are reflected in the surging stock market.
Meanwhile, most corporations have cut to the bone to adjust to a slower growth economy and a lower level of consumer spending. So, the big question to me is how are companies going to grow earnings going forward? We have long talked about how we try to focus on companies that lead their respective industries in terms of new product innovation.
In a sense we are trying to identify companies that will continue to demonstrate above average research & development productivity. Unfortunately, looking at the amount of money spent on R&D is of little value. According to a study by Booz Allen Hamilton entitled "Global Innovation 1000 - Money isn't Everything", "There is no direct relationship between R&D spending and significant measures of corporate success such as growth, profitability, and shareholder return." The auto manufacturers are consistently at the top of the list in terms of the amount of money spent on R&D, yet it is hard to argue that it has resulted in corporate success. Pharmaceutical companies also make the top R&D spenders list, yet two of the largest spenders, Merck and Pfizer have dramatically underperformed the industry and the overall market over the last several years, as measured by shareholder return.
More broadly, rising development costs and shorter product life cycles continue to pressure R&D budgets across many industries. Henry Chesbrough, adjunct professor at UC Berkeley Haas School of Business, points out that a semiconductor fabrication facility costs Intel about $3 billion to build. Twenty years ago a similar facility cost $30 million, or 1% of the cost today. In the pharmaceutical industry, development costs for a successful new drug approach $1 billion, a ten-fold increase over the last decade.
Meanwhile, the life cycle for new products has fallen dramatically, raising the stakes for R&D spending. Product life cycles that were several years a couple decades ago, are now several months.
These ominous trends are forcing companies to search for creative ways to approach R&D. Joint ventures, collaborations, and licensing agreements are all relatively new ways that many corporations are adapting.
Going forward, innovation success will be driven more by flexibility and process, as well as a corporate culture of risk-taking, than by the magnitude of dollars spent. Since most companies are reluctant to divulge too much about their R&D efforts, evaluating their internal processes and corporate culture is difficult.
In our experience, the most successful innovators tend to lead on a sustained basis, primarily because flexibility, adaptability, and a corporate culture of risk-taking, if absent in a company, can not be produced overnight. A struggling company like Dell might want to be more like Apple in terms of new product innovation, but delivering on that goal is a whole different ball game.
