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     Oct 31, 2012


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".



Spengler is channeled by David P Goldman. His book How Civilizations Die (and why Islam is Dying, Too) was published by Regnery Press in September 2011. A volume of his essays on culture, religion and economics, It's Not the End of the World - It's Just the End of You, also appeared last fall, from Van Praag Press.

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