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Thursday, January 7, 1999

An Investment Opinion
by Dale Wettlaufer

Reversion to the Mean

I don't know if the investing world agrees with this, but I consider there to be a "commodity" return on equity (ROE). It's about 11%, which is the historical annual rate of return for broad equity indexes and, not coincidentally, also the historical rate of return on book equity for American corporations. Over the last few years, return on more broadly defined measures of invested capital have increased, ostensibly as American business has streamlined itself and increased productivity.

One could argue effectively that some of the large increases in return on capital for the S&P 500 companies is due to both the changing composition of the S&P 500 to include companies like Microsoft (Nasdaq: MSFT), and to the huge writedowns that have decimated book values. These writedowns aren't just the pell-mell big baths such as "restructuring charges" and the like -- they include huge hits to owners' equity pursuant to FAS-106, Employers' Accounting for Postretirement Benefits other than Pensions. Thus, normal earnings on lower equity bases give you higher ROEs. If you adjust book equity for some of these writedowns, ROE for the broad market is not as high as it looks.

I wouldn't argue that it's as low as it has been historically, either. American business is enjoying a number of developments that have pushed up ROEs, including low nominal cost of debt and increasing supply-chain efficiencies. The question that some investors have been wondering about is the reversion to the mean for U.S. corporate returns on equity, and by extension, a reversion to the mean for the U.S. stock market. If there is a reversion to the mean at some point within the next few years, how can this come about?

For one clue as to how this could happen, just look at the performance of the S&P 500 versus the performance of the small- and mid-cap publicly traded companies. The bifurcation between S&P 500 companies and the rest of the investment world is due to the fact that S&P 500 companies have generated better returns on capital than the rest of the market. Part of that is from lower debt costs, which allows a company to replace higher-cost equity with lower-cost debt or to show better pre-tax margins. Part of it, though, is from better asset productivity, or asset turnover.

Less cash going back into the asset base needed to generate revenues provides more cash for strategic spending or to return to shareholders via share buybacks. Keeping capital costs down is one way that corporate America has responded to long-standing pricing pressures across the globe. Listen to Jack Welch of General Electric (NYSE: GE) and this is the theme that you hear over and over again. In coming years, what does this mean for the broad sweep of American companies? One answer is that the reversion to the mean for ROE and equity market returns won't come from a huge stock market crash or a big recession that drops corporate profitability off a cliff. The reversion to the mean will come through further improvements to the supply chain of American business, resulting in better asset turnover and lower margins.

Why is it, for instance, that (Nasdaq: AMZN) shot up the other day when it said pricing was very aggressive? My take is that the company probably realizes that if it's not aggressive with prices, someone's going to eat its lunch, and the company would never get the market share in its target markets nor get the general mindshare with consumers necessary to push other strategic initiatives ahead. One of those initiatives, in my opinion, is as an aggregator of retailers. Like an online mall, retailers will pay a "lease" to be on its site because that's where consumers go when they think of shopping. This is where the high-margin revenues are going to come from in the business mix.

With books, videos, CDs, and basically commodity-type consumer goods, investors should be cheering margin declines for Don't hope for increasing gross margins. Wal-Mart (NYSE: WMT), for instance, didn't get where it is by trying to best Kmart (NYSE: KM) on margins. Wal-Mart focused on supply-chain efficiencies, inventory turns, customer retention, and low overhead to blow past Kmart. Because of these, it could earn a lower gross margin than its competitors and still generate a very high return on capital. Remember, return on capital is a function of margins and asset turns, and return on equity is a further function of leverage, or how much equity makes up the total capital base.

If enterprise resource planning software companies like SAP (NYSE: SAP), PeopleSoft (Nasdaq: PSFT), JDA Software Group (Nasdaq: JDAS), and JD Edwards & Co. (Nasdaq: JDEC) get corporations to thin out the asset bases of businesses, then the competitive front is pricing. Any company that can't compete on the former is going to have a heck of a time competing on the latter. Ever wonder why pricing announcements have always been a non-event to a positive event for Dell Computer (Nasdaq: DELL)? It's because its model is built for price competition while Compaq (NYSE: CPQ) historically hasn't been so well equipped.

Similarly, why do warehouse clubs Costco (Nasdaq: COST) and BJ's Wholesale Club (NYSE: BJ) generate excellent returns on capital with gross margins that are far less than half that of the typical grocery store company? It's because they invest less in the assets needed to get the product to you and price their inventory to turn quickly. Their suppliers thus finance their inventories just by providing receivables terms.

This, I would argue, is the way it's going to look across all sectors of the economy except where a company is selling intellectual property. That will always be a high-margin business that won't necessarily demand high capital turns. But the reversion to the mean for equity returns will be pushed by this "paradigm." Sam Walton was on this train long ago and so were the big-box retailers that have been such great performers. And within the last few years, companies such as SAP AG have added tens of billions of dollars to investors' capital by showing the rest of the companies in the world that can afford to license and implement its systems how to increase cash flow per dollar of capital invested in an enterprise.

The forward-looking companies in the country have already moved here. Thus, the rule-making dreadnoughts in the S&P 500 have performed better than the average publicly traded company by improving their business models. A company such as Procter & Gamble (NYSE: PG), for instance, is going to outspend in this area the generic brand companies that everyone was so afraid of in 1993. Even if that one generic diaper company didn't infringe on P&G's patent, it was still toast because of this.

Bottom line on these macro thoughts? Well, there are a few. First, this bodes very well for the ERP software companies. It's not a nice-to-have thing -- it's a need-to-have thing. Second, barring an exogenous shock to the market, the likely way the market will revert to the mean is a speeding up of asset turns and a decrease in margins for commodity goods, distributors, and near-commodity goods. Brand, for instance, is going to have to mean value as well as image. But that's not anything earth-shatteringly new, as a company like P&G knows. It just means they'll have to keep on working on delivering supply and distribution chain improvements and manufacturing efficiencies to the consumer.

For companies like, it means they're going to keep on pushing prices down as quickly as they can. The company that realizes that will reap the rewards of increasing market share without having to eat through all its capital. It'll be the company's vendors that finance it. In the near term, what would otherwise be working capital investment goes into brand investment. One is considered an income statement item, while the other is considered a balance sheet and cash flow statement item. However, they are both cash outflows, which is something many short-sellers haven't realized over the last year.

I expect that the shorts will be freaking out over the next couple years on's dropping gross merchandise margins. I fully expect the company's merchandise gross margin to get down to the 10% level over the next few years. That's not a negative, though. Keep your eyes on gross margins across corporate America. As asset turns quicken, margins will decrease. That's the nature of a competitive economy and the equilibrium of return on capital. Those companies that realize this first and make the decision to get there first, like Wal-Mart, will win the market share game and attain the nirvana of being the market share leader.

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