Small
US companies pose profit-less
riddle By Spengler
There's a simple reason why investors
avoid the smaller companies that contributed most
job growth in the United States during the past 40
years. They aren't making much money, and a lot of
them are losing money. Why should this be the
case? [1]
US corporations are sitting on a
US$1.7 trillion cash hoard, private equity firms
are sitting on a further $1 trillion in unused
commitments, and investment in plant and equipment
languishes well below the pre-crisis peak. The
great American job machine is broken because
Americans won't invest in each other's labor.
Exhibit 1: Non-defense Capital Goods
Orders minus Aircraft, 1992 Dollars Source: FRED
There's no
question that investment is down. Capital goods orders
in real terms are still 20% below their
2007 level (and a quarter below their 1998 peak).
It's even worse than it looks because a
disproportionate share of post-2008 capital goods
orders reflect overseas demand rather than
domestic investment.
A glance at the
returns to investment among smaller companies
helps explain the investors' strike.
Exhibit 2: Most US Publicly Traded
Companies Aren't Earning Much
Source: Finviz
The
average return on investment (ROI) for 3181 traded
US companies as of the second quarter was just
1.0%, versus 10.2% for the top 500 by market
capitalization. The long tail on the left of the
histogram shows that a large proportion of smaller
firms are losing money.
The picture is
even uglier for the 680 or so traded technology
companies. For every Apple, there are dozens of
money-losing middle-market and start-up firms.
Exhibit 3: Return on Investment for
Technology Companies Source:
Finviz
Apart from the top tier, tech
companies as a sector are money pits. The long
tail on the left reflects enormous losses on
investments for the majority of smaller companies,
whose average ROI is a negative 15%.
The
average, to be sure, gives the same weight to
struggling small-cap companies as to successful
large-cap companies. If we look at the aggregate
returns to smaller and larger companies, though,
we observe a widening gap during the past decade.
Comparing the return on assets to the S&P 500
to the return on assets for the Russell 2000 Index
of smaller-capitalization companies, we observe
that a three-point differential in favor of the
top 500 companies in 2003 has turned into a
six-point differential in 2012.
Exhibit
4: Return on Assets Gap Widens Between Big and
Small Companies Source: S&P
There are several possible
explanations:
1. We are in a technology
plateau in which fewer innovations are available
to entrepreneurs, and labor productivity will grow
more slowly. Prof Robert Gordon of Northwestern
University made this argument in a recent paper
that attracted extensive press.
2. The
shift in world economic growth towards emerging
markets favors the mass dissemination of existing
technologies rather than the invention of new
technologies;
3. Globalization sets a far
higher threshold for entrepreneurial success than
in the past, in terms of diversity of management
skills, global operations, technological prowess,
capital requirements and investor patience (this
is the thesis of a recent book, Entrepreneurship
and the Global Economy, by Henry Kressel and
Thomas Lento, which I reviewed in the Wall Street
Journal on September 27, 2012).
Kressel
and Lento observe that a quarter of investors have
taken all the profits from venture capital
investments in the past decade, which is to say
that three-quarters of all venture capital funds
have lost money.
4. The Obama
administration's hostility to business (in the
form of high business taxes, excessive and
capricious regulation, the high threshold costs of
expansion due to Obamacare) and associated policy
uncertainty discourage investors.
Whatever
the cause, the result is that firms with 500 to
1,000 employees, the biggest job creators in
previous recoveries, were the biggest shedders of
employment in the present economy.
Exhibit 5: Return on Investment for
Technology Companies Source:
BLS
There is doubtless some truth to
Prof Gordon's argument, and there is no doubt that
global competition puts headwinds in the way of
American entrepreneurs. There is no instant
solution to these problems. But there is a quick
solution to the fiscal and regulatory obstacles to
smaller American companies, and it requires a
change in administration in November. Without such
a change, we will never find out how formidable
the other problems may be.
Note: 1. This article is
adapted from Macrostrategy's October 26, 2012
report, "Flattened Profits".
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