Bill Miller 2nd Quarter 2003 Market Commentary
In 1927, British biochemist J.B.S. Haldane published a volume called Possible Worlds and other essays. In it was a paper titled "On Being the Right Size." Haldane begins that essay by noting that differences of size are the most obvious differences among animals, but that little scientific attention seems to be paid to them.
He shows that a consideration of the constraints of physics on form and function yields some surprising insights, including the answer to a question posed by a recent reader of New Scientist magazine who wondered if it was true "that you can drop a cat from any height and it will land unhurt because its terminal velocity is lower than the speed at which it can land unhurt." (No.) But Haldane says you can drop a mouse down a thousand-foot mineshaft and it will walk away, "so long as the ground is fairly soft." Not so with a rat, or any larger animal, if you were wondering.
Perhaps more pertinent to readers of this piece is that Haldane's essay offers insights into why we own none of the top five companies sized by market capitalization in the S&P 500, and why Internet stocks may be better values than conventional thinking might assume.
Small- and mid-cap managers explain that their universe of companies can grow faster than very large companies. Large-cap managers note that smaller companies are riskier and have higher failure rates than very large enterprises, perhaps negating whatever advantage may arise from the putatively faster growth rate. Small animals have shorter life spans, in general, just as small companies do. Is that a coincidence?
When is big too big, anyway? How much, if any, of a disadvantage is GE's market capitalization of $288 billion? Is it a coincidence that GE, Microsoft, Wal-Mart, Pfizer, and Exxon, the top five companies in the S&P 500 by market capitalization, all are worth between $244 and $288 billion, despite their being in five different businesses?
Haldane claims that for every type of animal there is an optimum size. People, for example, could not be 60 feet tall. Giants may exist in literature, but not on terra firma. Scaling up a person to 60 feet in height would increase his weight by a thousand times, and increase the pressure on each square inch of bone by a factor of 10. But human thigh bones will break trying to carry ten times human weight, so giants couldn't walk without breaking their thighs with each step.
The aerodynamics of flying quickly imposes limits on the size of birds. The muscle power necessary to flap wings inhibits how big a bird can be and still stay aloft. Very large birds, such as eagles or condors, mostly soar, flapping their wings relatively rarely. Hummingbirds, in contrast, can flap their wings faster than our eyes can register, because of their very small size. The constraints that physics imposes on form and function are sometimes useful to us. "Were this not the case, eagles might be as large as tigers and as formidable to man as hostile aeroplanes," Haldane observes.
Considerations such as these soon "show that for every type of animal there is an optimum size." Economists have not drawn much inspiration from biology, with some few exceptions, despite Alfred Marshall's noting that the economy is much more like a biological system than a mechanical one. The paradigm of the modern economist has been physics, not biology.
Darwin, though, drew his inspiration from economics. It was his reading of Malthus that spurred his thinking about the struggle for existence. He thought of nature as an economy, where each area of competitive advantage would be occupied by some organism. "Wedges in the economy of nature" was the phrase he used.
Haldane was writing about the physics of biology, about the limits of systems that are constituted in particular ways, or which are organized to solve specific problems, such as flying.
His point was that the basic nature of the world imposes limits on our ability to operate within it. If we are going to fly, we have to obey the laws of aerodynamics. The laws of optics, and the nature of light waves, have implications about how eyes must be constructed.
At the end of his essay, he says, "and just as there is a best size for every animal, so the same is true for every human institution." The reason the Greeks thought a small city was the largest size for a functioning democracy was that democracy required that all citizens be able to listen to debates about issues and vote on legislation. A large geographic area makes this method of governance unwieldy and unworkable.
When representative government was invented, it opened the way for a large landmass to be governed democratically, which first occurred in the United States. Haldane noted that broadcasting, then a recent invention, enabled every citizen to once again hear the views of legislators, perhaps leading again to experiments in direct democracy. California's use of the referendum and the current recall effort are examples of how technology, in this case mass media, can alter the structure of the polity. Haldane recognized that technology can perhaps change what is possible in ways that are not immediately obvious.
The collective psychology that is the market glimpsed something similar in the tech and Internet boom of the late 1990s. Exuberance that was irrational and valuations that were unsustainable do not negate the profound changes that may ensue due to ever-expanding computational power and the vast potential of the Internet.
Internet businesses operate in a different realm from that of most businesses whose physical world presence shapes their size, determines their opportunities, and constrains the returns available to their capital. We really don't know, or I don't anyway, just what the optimum or potential size is of Amazon, eBay, Yahoo, or InterActive, the four big public Internet companies. It is worth considering that these companies may have optimum or potential sizes that may far exceed those we now observe in our largest and most valuable businesses.
Amazon is often compared to Wal-Mart or Home Depot, usually by those who are bearish on it because "it is a retailer with a retailer's cost structure," as one investor who is short the stock was recently quoted. He went on to note that Amazon's market value was four times 2003 estimated revenues, while Wal-Mart and Home Depot, "the country's two most successful retailers, trade for about one times sales."
This reasoning is an absolute snake pit of confusion, the untangling of which is well beyond the scope of this letter. It is instructive, though, to consider a few of the errors infecting the argument.
Traditional retailers have a fundamentally different set of economics from Amazon due to the physical structure of the world in which they operate. They have to build stores, which not only requires capital but also depends on finding suitable locations, navigating local zoning law, and dealing, in the case of those outside the U.S., with restrictive, perhaps prohibitive, rules on pricing, hours of operation, and so on.
Wal-Mart will spend $12 billion of capital this year to grow its square footage by 8 or 9 percent. That is just about 5% of sales to get 12% sales growth, assuming same-store sales are up 4% or so. Amazon will spend 0.7% of sales to grow revenues 30%. The cost for Wal-Mart to open a store in Tokyo or stores all over Japan is orders of magnitude greater than it is for Amazon to put up a website and provide local distribution. Wal-Mart has to contend with almost a billion dollars of lost merchandise ("shrink") from its stores every year. Amazon doesn't. As a result of these and other factors, the economic model of Amazon is very unlike that of Wal-Mart and other retailers. The capital required to generate growth for Amazon is a fraction of what a physical world retailer has to spend to generate the same growth. As it grows, Amazon has the potential to generate returns on capital that are many times that of Wal-Mart and Home Depot.
Perhaps most puzzling is the valuation argument. What possible relevance could it have to Amazon's valuation that Wal-Mart and Home Depot trade at about the same multiple of revenues? They trade at very different multiples of earnings. Do earnings matter? Some retailers sell at fractions of sales, others at multiples of sales. Should all successful retailers sell at the same multiple of sales? Why? What does a calculation of the multiple of sales have to do with valuation anyway? Nothing.
The value of any investment is the present value of the future free cash flows of that investment. Even people who are bearish should know that. The magnitude and duration of free cash flow, discounted at an appropriate rate, determines value. We estimate Amazon will have about $350 million of free cash flow this year, over $500 million next and over $700 million the year after that. We may be right or wrong, but those are inputs that are relevant to Amazon's value, not where Wal-Mart or Home Depot happen to trade.
The market value of the four major Internet companies combined is just a bit more than the market value of Amgen. Is the investment opportunity in these four businesses combined worth more than one, albeit quite successful, biotech company? What is the right size for an Internet company? How big can they be?
Value is created by profitable growth in excess of the cost of capital. All of the major Internet companies have economic models far superior in terms of return on capital to most of the companies populating the average money manager's or investor's portfolio.
There is no reason to believe that the economic opportunities for the most successful Internet companies are not as great as those of the most successful physical world companies, who are sized now at about $250 billion or so of market value. Just as there are limits to how large a person can grow, there are limits to how large a company can grow. We don't know how big the top five S&P companies can be, but we think they are closer to their limits than the other businesses we own.
Size is an enemy of performance in companies as well as in money managers. As Warren Buffet so nicely put it, if you believe otherwise, you should pursue a career in sales, but avoid one in mathematics.
- Bill Miller, CFA
August 17, 2003
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