Look for paradigm shifts, part 2

As companies report their results from the first quarter of 2009, investors are noticing a divergence between companies reporting surprises that strongly beat expectations, and companies whose results can be seen as confirmation of the economic recession.

For example, today's Wall Street Journal calls attention to extraordinary earnings from Apple, which beat analyst estimates on continued strong sales of iPhones, while at the same time noting that "United Parcel Service, which is often seen as an economic bellwether, said its first-quarter net fell 56%, and projected second-quarter earnings short of analysts' estimates."*

Many times in the past (going back, in fact, to our very first blog post) we have quoted the assertion of Mr. Thomas Rowe Price in which he declared, "When selecting growth stocks, the most important requirement is capable, dynamic management operating in a fertile field of future growth."

We would note that in the examples from the Journal story above, the difference between the two companies might be expressed in terms of "fertile fields of growth." We have explained that one way of assessing fields of growth is to look for paradigm shifts, which open up new fields of growth as individuals or businesses change to a new way of doing things that adds new value.

In the case of the iPhone, it is clear that the rise of the smartphone (a category that the iPhone revolutionized upon its introduction in 2007) creates a fertile field of growth, the beginning of a paradigm shift that will eventually make traditional cellphones obsolete. In the case of UPS, it is clear that while they helped create a paradigm shift away from reliance on traditional postal service, that paradigm shift has largely penetrated most of society, and they are today much more tied to the cyclical ebbs and flows of the economy.

In our previous study of the difference between the broad investment periods of the 1970s, 1980s, and 1990s ("Return of the 1970s, part 2") we suggested that during periods of strong economic expansion (such as the period from 1984 to 1999), companies which had already grown to dominate their industries often did well, growing their sales and benefiting from strong liquidity and commanding balance sheets. During that period, and during the 1960s as well, large stocks generally performed well, as did index funds favoring large stocks such as the S&P 500 or the 1960's "Nifty Fifty" (a sort of large-cap index popular at that time).

During the economically rocky 1970s, however, there was a serious divergence between the performance of larger companies and smaller ones. Larger companies, whose businesses were less likely to be exploiting a new paradigm shift and were thus likely to be more tied to the ups and downs of the overall economy, lagged significantly. Smaller companies, which were more likely to be dependent upon some new field of growth for their opportunity to make money, considerably outperformed during that decade and into the early 1980s, in spite of the vicious 1981-82 recession.

We would suggest that there is evidence that the same phenomenon may be starting to take place today. Investors should therefore be thinking carefully about where there are fields of growth, or paradigm shifts, and what companies can best pursue them.

As we stated in our previous post on paradigm shifts, "a paradigm shift can take place from the creative application of almost any new and more efficient business model, whether it uses some new technology or not." In other words, the field of growth can arise from a very subtle trend.

For example, Quest Diagnostics, which just reported 20% growth in earnings over the results of the same quarter in 2008, is taking advantage of a variety of trends that point towards greater use of lab testing. One trend is that lab test usage increases with age, and the demographics in the US and other countries are such that we will witness an aging population in the decades ahead. Another trend is toward greater use of diagnostic testing sooner, in order to provide physicians with greater situational awareness on a more timely basis. Related to this trend is a growth in esoteric testing, laboratory tests which require greater human analysis from trained personnel and which are often used to detect less common health issues. These tests are often more expensive and carry higher margins for lab test providers such as Quest Diagnostics.**

These types of paradigm shifts are perhaps less obvious, but represent the kinds of fields of growth that well-run businesses may be able to follow for many years. Investors should carefully consider this concept, especially at a point in time where there may be an increasing divergence between companies that meet the definition of "capable, dynamic management operating in a fertile field for future growth," and those that do not.

* The principals of Taylor Frigon Capital Management do not own securities issued by Apple (AAPL) or United Parcel Service (UPS).

** The principals of Taylor Frigon Capital Management own securities issued by Quest Diagnostics (DGX).

For later posts on this same topic, see also:

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