What's the difference between an economic expansion fueled by top-line revenue growth and an economy that depends on cost-cutting and extraordinary gains in productivity for its growth? The first results in a strong economy and stock market that lifts the fortunes of well-run companies and inefficient companies alike, much like we witnessed in the 1990s. The second results in an economy and stock market plagued by slow growth, relentless global competition and rising prices for energy and raw materials. In that environment, inefficient producers are toast. At the same time, disproportionate shares of corporate profits go to the most efficient companies in a given industry. They're able to use the earnings that come from higher margins to reinvest in new capital equipment and faster new product development. That's the economy I believe we face for the next 10 years. The result will be a winner-take-all stock market where the shares of sector winners will gradually pull further and further away from the pack. How do you pick winners in a winner-take-all market? First, it's critical to understand the trends that have created this economic situation. Then, you have to be able to identify the companies that are using research and development budgets to create new products to profit from those trends. Here they are.
What's called "productivity growth" played an extraordinarily large role in that profit jump. With output per hour worked up 4.4% in 2003, after a 5% jump in 2002, companies are able to produce more goods and services with the same number of workers, the Commerce numbers show. Or the same amount of goods and services with fewer workers. Either way, that's a huge boost to company profits. (Especially since hourly wages aren't going up significantly right now.) That kind of productivity growth is way, way above historical trends. The long-term annual average for the last 55 years is just 2.3%. But a surge in productivity isn't all that unusual as an economy comes out of a recession. Companies have spent the last two to three years cutting workers, shutting their oldest, least efficient plants and trimming fat in everything from office support to shipping to sales. As the economy revs up, that's supposed to lead to increased profits that go into capital spending budgets as companies reinvest in their businesses to meet projected demand. This is the stage that we've been waiting to see kick in for the last year. Capital spending was up a real (that means subtracting for inflation) 14% in the second half of 2003; Citigroup economists project a 10% rise in the first half of 2004. That's a move in the right direction, but it's still anemic compared with what usually happens as an economy bounces back from a recession. Along with the slow jobs recovery, the slow recovery in capital spending is the key reason that this remains a weaker-than-normal recovery. Some of the weakness in hiring and capital spending comes from corporate skepticism that this recovery will lead to sustained demand growth. Just as important for capital spending, the recovery of the economy as a whole hasn't yet led all sectors and all companies out of the profit desert.
The recovery has done little to solve the long-term profit problems facing the big telecommunications service companies. Prices for long-distance are still falling, and the big wire line companies are still losing customers to wireless providers and increasingly to companies selling phone service over the Internet. Is it any wonder that companies such as SBC ( SBC) and BellSouth ( BLS) have told Wall Street that their capital spending budgets will barely increase for 2004 from 2003?
And the more that a Cisco, an Intel ( INTC), a Schlumberger ( SLB), a Taiwan Semiconductor Manufacturing ( TSM) outspends competitors on more efficient new machinery, the more that profitability gap will increase. Open that gap wide enough, and it's almost impossible for a competitor to challenge a more profitable top dog. That's the problem that Advanced Micro Devices ( AMD) faces as it continues to chase Intel. Intel's trailing 12-month gross margin is 73% to AMD's 62%. Intel's net profit margin is 19%, but AMD hasn't shown a full-year profit since 2000. In 2003, Intel spent $3.7 billion on a new plant and equipment to make the world's most efficient and profitable chip maker more efficient and profitable. AMD spent just $577 million. This isn't a game that AMD can win. Over the long term, this kind of imbalance results in a winner-take-all industry.