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 (NASDAQ:DISH) has spent billions launching satellites to distribute content to its customers. And the more customers who subscribe, the faster these costs to the company per customer fall, increasing returns for EchoStar.
Video game maker Electronic Arts (NASDAQ:ERTS) is another company that generates increasing returns. It costs millions of dollars to develop new games, and the first game that goes out the door is very expensive. But every game after that gets cheaper and cheaper, increasing returns for Electronic Arts with every game sold. And to the company's benefit, Electronic Arts sells lots of games.
2. Learning effects
Cumulative knowledge can generate increasing returns, too. Companies such as General Electric (NYSE:GE) and aircraft maker Boeing (NYSE:BA) have been designing and manufacturing highly engineered products for decades now. They know how to design, manufacture, and reduce the costs out of their complex projects, giving them an advantage over rivals and helping them get more out of their investment dollars with each passing year.
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 (NASDAQ:NFLX), for example. Sure, it spends money to acquire customers, but it could benefit even more from people seeing their friends use Netflix. Then they tell two friends, and so on, and so on. This can lead to a critical mass of customers that can produce increasing returns over time.
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 (NASDAQ:EBAY). As more customers used eBay, the auction market expected more customers to sign up, which in turn attracted more customers, making eBay's growth almost like a self-fulfilling prophecy.
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 (NYSE:WU). Lead analyst Philip Durell recognized this company's special characteristics and kept it in the portfolio after it was spun off from Inside Value recommendation First Data.
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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.
