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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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This school of thought holds that stocks like those of the Dow Jones Industrial Average materialized out of nowhereLate in the nineteenth century, Dow was perceptive enough to see that new methods of taking natural resources and mass-producing enormous quantities of goods were revolutionizing how business was done. Eventually this would be called the take it, make it, break it business model. Dow created the Dow Jones Industrial Average in 1896 to be the barometer of the new types of companies that had taken over the driver s seat of the American economy. The tag, Dow Jones Industrial Average, identified the dominant investment of the twentieth century. Once named, the dominant investment becomes an institution. A web of interests forms a symbiotic relationship with it. A bureaucracy is created the web of the dominant investment system (see Figure 1.2). The tricky thing about dominant investment systems is that they are like driving a container ship. It takes a while to overcome inertia to get the momentum going, and it takes an equally long time to stop it. It takes investors a while to warm up to a new dominant investment and once they do, they dont want to let it go. The investment community takes this stodginess to an even higher level for fear of offending the multitude of interests, outside of the markets themselves, that have become vested in maintaining the status quo. The Wall Street Journal, for example, can be expected to be polite, but hardly enthusiastic, about this book because that paper as well as Barrons is owned by Dow Jones and Company and this is only one powerful piece of the bureaucracy vested in keeping an old culture alive. Benjamin Grahams ideas hit this same sort of brick wall nearly a century ago. At another epic turning point in financial history, when an investment culture that had operated for decades was dying on the vine, the securities of the new one that was to replace it, namely Dow stocks, were collectively derided as a fad appealing to a lowbrow and uncultured sort of investor. The more sophisticated, schooled, and discriminating preferred to keep most of their money where they always had in the securities that never lost money if you kept them for the long term, that eventually always outperformed all others, and that provided the template for how investments should be analyzed. That these securities were bonds, more specifically railroad bonds, stands as a monument to how dramatically an accepted system of perceived facts can be turned upside down. During the 1800s, bonds had provided the same set of blue-chip characteristics on which we had come to rely from Dow-type stocks in the 1900s. Bull bond markets brought impressive capital gains to investors in the nineteenth century. Annual returns of 30% and even higher were not uncommon.4 Although every year was not so lucrative, the average annual returns succeeded in making bonds the dominant investment of the nineteenth century. Figures 1.3 and 1.4 show how similar the growth rate of bonds in the nineteenth century was to Dow stocks in the twentieth. This version of market history differs from what can only be called the Adam and Eve school of investing. This school of thought holds that stocks like those of the Dow Jones Industrial Average materialized out of nowhere, begat the S&P 500, and together will forever dominate the earth. This conveniently avoids the pesky fact that the same evolutionary process that allowed the Dow to supplant bonds as the dominant investment can create a replacement for the Dow itself. The chemistry behind these transitions is refreshingly straightforward. PRODUCTIVITY: THE HEARTBEAT OF A DOMINANT INVESTMENT Without the long history of productivity growth, incomes would not have risen, life would not have improved, immigrants would not have flocked to these shores, and people could not have moved off the land and into cities. In short, our whole history would have been radically different. Jeremy Atack and Peter Passell, A New Economic View of History5 Wealth is created by generating more output with lesser input. This is productivity. Not only will a method of doing business that increases productivity enhance profits for the companies that use it, but Note: The dominant investment of the 1900s follows a pattern that is similar to that of the dominant investment of the 1800s. the surrounding economy will benefit due to what economists refer to as the multiplier effect.6 Combine agriculture with a brand new railroad system, for example, and you will have what we call the pick it and ship it business model that succeeded in raising American productivity to an annual growth rate of 2.6% for much of the 1800s. Divergent opinions exist as to the rate of economic growth prior to the 1830s. But Robert Martin (who conducted research in the 1930s); Nobel laureate Simon Kuznets; and agricultural historians Marvin Towne, Wayne Rasmussen, and George Rogers Taylor all agree on one point: A major acceleration of self-sustaining growth occurred in the 1820s and 1830s and is attributable to the railroad.7 Throughout the nineteenth century railroad bonds were the best way for investors to capitalize on the wealth that this business model generated for the economy and for companies themselves. By the time the energy started to come out of the pick it and ship it business model in the 1870s and productivity fell below 2%, the belief that rail bonds would always be the best place to invest for long-term growth was deeply ingrained in the collective consciousness. This belief sustained rail bonds as the dominant investment for many more years, despite the ominous drop in productivity. Late in the nineteenth century a new and more productive method of doing business had evolved: the take it, make it, break it model mentioned earlier. In the book Surfing the Edge of Chaos,8 the authors explain that productivity was rejuvenated by taking vast quantities of natural sources, making products to be mass marketed, and then replacing breaking them, so that the process can be repeated. This fundamentally altered how business was done in the United States and ushered in productivity growth rates as high as 3% for much of the twentieth century.9 While Charles Dow was probably not monitoring productivity numbers, he was enthusiastic enough about the new business methods to discontinue publishing the list of railroad stock prices he had been using since 1887. He wanted his index to represent the new style of company. On May 26, 1896, he published his first average, which excluded railroad companies and contained only take it, make it, break it companies. Three years later stocks outperformed bonds for the first time in history (see Figure 1.5). Almost exactly 100 years after the take it, make it, break it business model rejuvenated the U.S. economy by improving productivity, it has been replaced with an even more productive model that we call realize, capitalize, customize. The juice behind this transformation is the science of semiconductors, which turns information into an energy that is more powerful and efficient than anything that can be pumped from a pipeline. The importance of semiconductors to U.S. business in the twentyfirst century is one of the main courses of study at the best business schools in this country. The reading list in Appendix G contains mustread titles on the subject. In one of the best, Unleashing the Killer App, the authors have this to say about the new power that the delivery of information has on business: Executives in industries as varied as education, advertising, government, pharmaceuticals, consumer products, retail, and wholesale tell us their basic assumptions about products, channels, and customers will be completely changed.10 In the book The Next Economy, marketing guru Elliott Ettenberg said the following of companies clinging to take it, make it, break it: Existing corporate structures and measurements of success are incapable of guiding enterprise through the coming changes. To survive Note: As the twentieth century began, stocks outperformed bonds for the first time. Source: Historical Returns and Security Market Development 1872-1925 by Kenneth Snowden in Explorations in Economic History, vol. 27 393, 1986. Elsevier Science (USA), Reproduced with permission of the publisher. and prosper in the Next Economy will require a rethinking of corporate priorities.11 Growth in the old industrial business model came from building ever larger corporate bureaucracies, exploiting ever more natural resources, organizing hierarchies of management and regulating competition. Realize, capitalize, customize is the polar opposite. A new product or service is created and tested in a virtual setting. Creativity and experimentation can be encouraged because trial and error are nearly cost-free. The new project does not have to be overseen by a raft of bean counters. Once the new product is realized, it can be capitalized via partnerships with suppliers, manufacturers, and venture capitalists or by issuing stock through the capital markets. Customization via the ability to gather and rearrange data adds value for the consumer at no added expense to the company. Elliott Ettenberg says that one of the main differences between the twentieth century and the twenty-first century consumer is that the fulfillment of needs described the twentieth-century business. People needed cars. The twenty-first century companies will profit by fulfilling wants. Todays consumers want an off-road vehicle, a sports car, and a family car. Consumers used to need clothes; today they want one set of clothing for the office, another for the golf course, and still another for social events. The profitable company in the twenty-first century uses information management to keep up with key consumers and customize products to fulfill these wants. Nike is an example of a take it, make it, break it company that has adopted the realize, capitalize, customize model. In the old days they would have expanded by building more shoe factories and buying more trucks and railroad cars in order to mass market a new line of shoes. They would hope to make a profit by prevailing in adversarial negotiations with suppliers, merchants, and customers. Instead, today Nike outsources its manufacturing and distribution to partners connected to Nike by digital information systems. By getting out of the shoe factory business, Nike is free to leverage its brand identity as an athletic company by using high-bandwidth communication channels to promote and manage sporting events. Nike can customize its product line by targeting the wants of the basketball fan differently from the wants of the tennis buff. The adoption of the new business model by many corporations caused annual productivity growth to soar from 1.25% during 19701994 to an annual average rate of 3.75% at the turn of the twenty-first century.12 That this is a permanent structural shift is confirmed by leading economists: In 2000, chairman of the Federal Reserve Board, Alan Greenspan, stated, When historians look back at the latter half of the 1990s, a decade or two hence, I suspect that they will conclude we are now living through a pivotal period in economic history. Likewise, David Wheeler, vice president of the Federal Reserve Board, remarked in 2001 that the increase in productivity growth during the past five years is due to permanent forces, mainly the diffusion of information. The effect of the new source of productivity on corporate America is no less than that of the asteroid that caused the extinction of the dinosaurs. Smaller companies can now be more profitable than larger ones; costly exploitation of natural resources is unnecessary; teams of employees are more efficient than management bureaucracies; and networks of companies in partnerships are more efficient than turf battles. The economic slowdown of 2001-2002 shows the power of productivity. Figures 1.6 and 1.7 indicate the loss of jobs in the manufacturing and industrial sectors. It is clear that these less productive, largely twentieth-century businesses, had to get rid of employees way before the recession set in late in 2001. It is equally clear that these types of companies curiously perceived as safe or as the backbone of our economy offered no place to hide when times got rocky. Figure 1.8 lays out a different picture. In 1999, a peak year for the economy, manufacturing and industrial companies were getting rid of employees. Yet data processing and computer services industries could not hire people fast enough. Even more revealing, as the recession set in, the number of job losses in this sector were far lower than were those in the industrial and manufacturing sectors. The more productive companies barreled on through the slower economy. Suppose we took the labels off of these figures. In a blind test we tell you that each graph represents a different set of companies. Which set would you pick to invest in? Would you not choose the companies represented in Figure 1.8? Obviously, they are more robust and are less affected by crises like economic fluctuations or the attack on the World Trade Center. By and large these are the companies of the new dominant investment system. Most of these companies are found on the NASDAQ stock market. |
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