At the Berkshire Hathaway annual meeting, Warren Buffett said, "For society, the Internet is wonderful, but for capitalists, it will be a net negative. It will increase efficiency, but lots of things increase efficiency without increasing profits. It is way more likely to make American businesses less profitable than more profitable." Charlie Munger agreed, saying, "This is perfectly obvious, but very little understood."

The argument is very simple and compelling. By allowing buyers to search quickly and easily for the best prices worldwide, or to create competitive bidding situations via auctions and the like, the Internet will remove pricing inefficiencies and force overall margins down. To some extent, sellers will be able to mitigate this effect by using technology to increase efficiency, but since technological innovations are generally widely available, the benefits will be captured primarily by the buyers. To use an analogy, if one person in a crowd stands on tiptoes, that person may see better for a short while, but soon everyone will be standing on tiptoes, with the result that no one is better off.

Asked to elaborate at the Wesco annual meeting, Munger restated his view and asked, "Can anyone tell me how the Internet is not going to reduce average profits?" I stood up and said roughly the following (I wish my thoughts had been this organized):

"I agree with you that profit margins will decline, but as an investor, what I care about is return on invested capital. The same factors that are driving margins down are also allowing companies to streamline inventories and greatly reduce the amount of capital tied up in their businesses. Look at the success of one of your favorite companies, Costco, or one of my favorites, Dell. They are generating high returns on capital, not to mention fabulous shareholder returns, on razor-thin margins. Therefore, it's not clear to me that investors will necessarily do badly even if average margins are squeezed."

Munger replied, "That's why I was careful to use the word average. There is no doubt that some companies will benefit, but it's not good news for other retailers when Costco opens up nearby. On average, the industry will not be better off."

Perhaps, but I've had a few other thoughts since this exchange. First, let's define the question clearly. I believe the underlying question is: Will the typical American industry suffer from declining average profit margins and returns on capital over the next 10-20 years, resulting in inferior returns to shareholders (holding constant interest rates, investor enthusiasm for stocks in general, and other exogenous factors)? Munger says yes. I'm not saying no, but I think there are at least five factors that could mitigate the dire scenario that he envisions.

First, I think it is likely that over time the most efficient, adaptable, and, in all likelihood, highest-return-on-capital companies will gradually come to dominate most industries. While Munger is correct that less successful companies will drag the industry average down, I would argue that as the most successful companies thrive, their economic characteristics will increasingly become the industry average. Dell's (Nasdaq: DELL) 292% return on invested capital (as reported in its most recent earnings release) has a much bigger impact on the industry average today than a few years ago, given that Dell's market share is many times larger. Similarly, an investor who years ago bought equal stakes (or even market-share-weighted stakes) in the top five or ten leading PC manufacturers would have done extremely well, even though some companies have done very poorly, because the stock gains of the successful companies have more than offset the losers, and the winning stocks would have become dominant in the portfolio. I believe a similar outcome would have emerged had one bought Costco (Nasdaq: COST), Home Depot (NYSE: HD), or Staples (Nasdaq: SPLS) and each of their top competitors years ago.

Second, total profits might not decline for two reasons:

a) While gross margins will certainly get squeezed, net margins could actually rise as companies use technology to reduce their numbers of employees, distribution costs, etc. Dell is a good example. From FY 1992 to FY 2000, its gross margin plunged from 31.7% to 20.7%, yet its net margin rose from 5.7% to 6.6% (7.4% pro forma);

b) A basic rule of economics is that lower prices lead to higher demand. If demand rises enough, total profits can actually increase despite slimmer margins. Anyone who's ever shopped at Costco knows how the rock-bottom prices stimulate tremendous demand.

Third, even if profits do decline, returns on capital could actually increase as I noted above. This, in turn, could lead to higher stock market valuations despite lower profits since all other things being equal, the market generally awards high-ROIC companies with high valuation multiples.

Fourth, as Buffett mentioned, there have been wonderful technological advances for decades (if not centuries) that have improved productivity, reduced pricing inefficiencies, etc. The impact of some of these advances might even be comparable to the current and potential impact of the Internet -- consider, for example, the widespread introduction of the telephone. Yet profit margins and returns on capital have, if anything, increased, and investors have consistently earned strong returns.

Finally, American industries do not operate in a domestic vacuum. While it's possible that profits in this country could decline due to increased competition, there's a big world out there where excess profits might be generated for decades. It's my impression that American companies are doing a pretty good job of competing, taking market share and earning increasing profits in less efficient markets overseas. Coca-Cola, for example, in 1999 generated 62% of its revenues but 68% of its operating income outside of North America.

These five factors lead me to question Buffett's and Munger's prediction about the consequences of the Internet for investors. They may well be proven correct -- I sure wouldn't bet against them -- but I don't think the outcome is "perfectly obvious."

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at To read his previous guest columns in the Boring Port and other writings, click here.