What's better -- decreasing returns or increasing returns? It's not a trick question. Of course, we all want increasing returns.
But doesn't competition kill returns over time, making us doomed to wallow in a world of decreasing returns? Over the very long term, yes. But there are companies with increasing returns out there, and in "Self-Reinforcing Mechanisms in Economics," economist W. Brian Arthur gives us four things to look for to find them.
1. Large setup or fixed costs
Some companies invest lots of money up front in order to reap big rewards down the road. Satellite TV provider EchoStar Communications
Video game maker Electronic Arts
2. Learning effects
Cumulative knowledge can generate increasing returns, too. Companies such as General Electric
3. Coordination effects
Coordination effects is a fancy way of saying "monkey see, monkey do," as companies benefit from customers imitating each other. Take Netflix
4. Self-reinforcing expectations
And that critical mass of customers can even produce winner-take-all situation. Self-reinforcing expectations refers to the situation where as a company's market share increases, it continues to increase because customers expect it to increase. The classic case is VHS video cassettes killing off Beta tapes, despite VHS being considered a lesser technology. The other is eBay
Even great gigs don't last forever
Although some companies have returns that can increase for long periods of time, returns cannot increase forever, just as a tree cannot grow to the stratosphere. But companies with increasing returns can generate lots of value during their heyday. Just look at what the aforementioned have done since coming public:
Company |
Annualized Return Since IPO |
---|---|
Electronic Arts |
30.8% |
EchoStar |
27.7% |
General Electric |
15.4% |
Boeing |
17.6% |
Netflix |
36.1% |
eBay |
42.2% |
Pretty impressive, no? These stocks have doubled, tripled, and then some! A $1,000 investment in eBay back in 1998, for example, would be worth more than $15,000 today. And, yes, that's how I define "and then some."
Another company that benefits from increasing returns is money transfer company Western Union
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This article was originally published on June 22, 2006.
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At the time of publication, David Meier does not own shares in any of the companies mentioned. Electronic Arts, Netflix, and eBay are all Motley Fool Stock Advisor recommendations. The Motley Fool has a disclosure policy.