On the verge of something important

Above is a chart from the Federal Reserve showing the US Gross Domestic Product (GDP) for the period April 1998 to April 2010 (the most recent data -- GDP data goes through multiple revision periods, so the latest data is always a few months old).

Many investors may be surprised to learn that during that period, the US GDP has grown from $10.19 trillion to $13.19 trillion -- an increase of $3 trillion or almost 30%! This increase, by the way, has not been due to inflation: the data uses "chained 2005 dollars." What is shown in the chart is an actual increase in the economic value of goods and services produced in the US over that time period.

In contrast, equity values have hardly grown at all. The S&P 500, for example, went from 1,108.15 to 1,178.10 over the same time frame (the first of April 1998 to the first of April 2010). That's an increase of only 6.31%. As of the market close yesterday, the S&P 500 was only 1,147.70, making the percentage of total increase since 1998 a mere 3.56%.

This data in and of itself suggests that broad equity values may catch up at some point to reflect the greater value that is present in the overall economy. However, we also feel strongly that investors should seek out the most innovative companies for capital investment, and that much of the economic growth will be driven by exponential technology advancement.

While the growth in the overall economy from ten trillion to thirteen trillion dollars of output value is significant, that growth is tiny compared to the growth in technological capability between 1998 and today. In particular, we are referring to the ability to send and receive massive amounts of data extremely rapidly -- and increasingly, wirelessly.

As the above statistics from Limelight Networks illustrate, the capabilities for sending information in the mid- to late-1990s were paltry in comparison to what we enjoy today, and those capabilities continue expanding at exponential rates.* Also, the cost for sending, receiving, or storing data has become more and more inexpensive. Incredible improvements have taken place in the amount of data that can be sent, the speed at which it can be sent, and the cost at which it can be sent.

Increasingly, these improvements include the mobility of what is sent as well. According to this Cisco Systems study of mobile data trends, AT&T reported that their mobile traffic has increased 5,000% over the past three years.*

This combination has already had a transformative impact, not only on our use of popular entertainment and information media as consumers, but also on business functions in a wide range of industries. As large as that impact has been in the past ten to fifteen years, we believe it is still in its infancy. The potential business applications for nearly free, nearly instant transmission of vast amounts of data, including video data, have not yet begun to be worked out in various industries around the world.

Again, the incredible technological advances we enjoy today, real advances which simply did not exist in 1998, have come to pass alongside virtually no net increase in the advance of the price of the market, measured by broad indexes such as the S&P 500. Much of this is due to wild market disruption induced in large part by erroneous "over-steering" by the Federal Reserve and government.

Although it is clear that this over-steering will continue, and that government interference can create obstacles to progress, we believe there are inexorable forces at work that will continue to drive these advances in ways that even government ineptitude cannot derail. For more on that subject, see our previous posts on the work of the great economist Joseph Schumpeter and our original post on "The Unstoppable Wave."

In fact, we believe that we could be on the verge of something very big, very positive, and very important. This is not a market prediction -- we have made it clear that we do not pretend to divine upcoming market moves -- but it is a business prediction.

In light of that, we believe investors should be certain to align their capital with companies that are positioning themselves to drive these business changes or to benefit from them.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Limelight Networks (LLNW) or AT&T (T). At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Cisco Systems (CSCO).

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Have you heard of this company? CHRW

We have stated in the past that good investment is not rocket science, which can only be practiced by the initiated few, but rather that it is very possible for the average investor -- given the proper tools, discipline, and understanding of business principles -- to be successful (see this previous post, for example).

This message is contrary to much of what is heard from the representatives of financial services firms, as well as from the financial media, both of whom have a vested interest in making their listeners feel they need to listen to the "fast money" or the "big boys" or some other anointed class and depend on their recommendations.

On the other hand, while it is certainly possible for the average person to make investment management decisions for himself, it is important that those who decide to do it for themselves have a solid set of business-based criteria and the willingness to do the in-depth study required to determine if a potential investment meets those criteria. Also, if they opt not to do it for themselves, they should make the effort to ascertain what process the person to whom they delegate that responsibility will employ in his asset management decisions.

We have discussed in some detail the criteria we use as asset managers, and which we believe are important in assessing a potential business investment (see here, for example). Some of the most important include the trend in profitability measures such as return on equity, return on assets, operating earnings growth, as well as measurements designed to determine how the company has used capital to finance its growth.

We have also from time to time outlined businesses which we believe are exceptionally well-run and which are positioned in front of potentially fertile fields of future growth (see for example discussions of II-VI, Hittite Microwave, Dolby and Resmed)*. We hope that these companies will help to illustrate examples of what we would call "classic Taylor Frigon growth companies."

Another company we have owned for many years in our Core Growth Strategy -- since October of 2004, in fact -- is global transportation services provider C.H. Robinson Worldwide*.

C.H. Robinson is what is known as a "non-asset third-party logistics firm." Third-party logistics (3PL) companies coordinate shipments for their customers, who choose for business reasons to outsource some or all of their logistics requirements so that they can concentrate on their own core competencies. The reason that they are known as "third-party" logistics firms is that the 3PLs generally turn around and hire other transportation firms to do the actual transportation.

Some of these 3PLs use a combination of their own logistics and transportation assets to accomplish some of their customers' shipping and hire other transportation firms for other customer jobs (in which case they are often referred to as an "asset-lite" business model), and some 3PLs own no transportation assets themselves but hire others to do all of the work (in which case they are often referred to as a "non-asset 3PL").

C.H. Robinson is a non-asset model: they own no transportation assets themselves, but instead use a keen understanding of their customers' business needs, a network of relationships with a variety of transportation asset owners, and the capabilities of modern technology to drive higher efficiencies for their customers than they might be able to achieve on their own.

There are a tremendous number of companies in virtually every industry which require shipment of their goods to their customers. The 3PL value proposition to these shippers includes the reduction of fixed-asset requirements (shippers no longer have to maintain their own trucks or other transportation assets), the reduction of inventory costs, the reduction of order fill times, and an increase in flexibility and customer service.

A recent survey on the state of global logistics led by Capgemini Consulting found that, out of the variety of shippers of all types of goods surveyed in both North America and Europe, 47% of total 2009 logistics expenditures by shippers in North America and 66% of total 2009 logistics expenditures by shippers in Europe were spent on outsourced logistics, and that all geographies anticipated increasing those percentages over the next five years.

Further, the ongoing increased freedom for private enterprise in China, India, Vietnam, and other formerly un-free nations has for the past two decades increased the number of firms who have moved some or all of their manufacturing production overseas, creating growing need for intercontinental shipping as part of their business model.

Companies such as C.H. Robinson Worldwide, which have global reach and the ability to coordinate land, sea, and air transportation (as well as "intermodal" transportation in which they supervise the shipment of goods on more than one mode of transport) are uniquely positioned to add value to shippers in need of such capabilities.

Finally, the technology aspect of this investment thesis is very important. We have in the past discussed the tremendous opportunities being created by the "unstoppable wave" of networked communications -- in which greater and greater amounts of data can be sent more and more quickly for less and less cost. While this ongoing paradigm shift creates tremendous opportunities for companies that are enabling those bandwidth improvements, it is also creating opportunities for other businesses in other industries who are able to apply those new capabilities to improve their own offerings to their customers.

In the logistics world, the ability to provide real-time visibility of a customer's shipping task and more timely alerts is extremely valuable to a customer. The bandwidth revolution taking place right now provides innovative logistics service providers such as C.H. Robinson Worldwide the ability to provide that valuable information to their customers.

While there are countless complicated factors which influence the demand for shipping worldwide, factors which can change rapidly from day-to-day, we believe that the measurable efficiencies that shippers can gain from an experienced 3PL provider such as C.H. Robinson will continue to drive demand for their services. We also believe that there are clear differences between the capabilities of 3PL firms, and that C.H. Robinson has demonstrated that they can provide superior services that shippers will seek out.

While it is very easy for investors to become caught up in the news of the day and the predictions of the economists and "big money" investors they might hear on the financial media, we always try to steer the focus back to the critical task of finding well-run businesses in front of potential fields for future growth, and that C.H. Robinson is a good example of the types of businesses they should be looking for.

* The principals of Taylor Frigon Capital Management own securities issued by II-VI (IIVI), Hittite Microwave (HITT), Dolby (DLB), Resmed (RMD), and C.H. Robinson Worldwide (CHRW).

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The political winds are swirling

It would be disingenuous to pretend to ignore the political winds swirling this electoral season, so we will venture to point out the investment implications that we see coming from the current election.

Our view is that anything that advances the ability of private enterprise to operate freely is ultimately good for the economy. We believe (along with Thomas Jefferson) that persons and businesses should be allowed to manage their property and their affairs without government interference, as long as they do not initiate violence or perpetrate fraud. Government should prevent both fraud and violence, which is its lawful role.

The over-reach of government is now painfully obvious to even the most casual observer of economic activity. We would add that this over-reach has been bipartisan in recent years! If the upshot of this very interesting political season is less government over-reach, then that will be a good thing for businesses and for investors.

We would also like to add, in the spirit of Friedrich Hayek, that we are not arguing for a "free-for-all" in which enterprise can operate in an environment without rules, akin to roads and freeways with no lines, stop signs, traffic lights or right-of-way conventions. Hayek argued that government has a legitimate role to play in establishing predictable and orderly markets in which free enterprise can then operate.

We discuss this important distinction between "free markets" and "free enterprise" in several previous posts, including here, here, and here. We also pointed out the important work of Professor Amar Bhide in exploring this dynamic over the years, particularly in this recent essay and in his newly-released book.

This last topic has other implications which we will explore in later posts, particularly surrounding the unpredictability of monetary policy under the central bank, which places businesses in the position of drivers who never know how the traffic rules will change as they drive down the road.

However, the main lesson of the gale-force winds building in the political landscape is that anger at the government over-reach that has been expanding in America for over seventy years is finally boiling over, and that should ultimately improve the ability of businesses to innovate and grow.

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What battles of the tech titans tell us about investment theory

The news recently provides some valuable data points which we believe confirm the arguments we have been making on these posts for the past two years concerning the "unstoppable wave" (see for instance here, here, and here).

First, Dell and HP got into a ferocious bidding war over utility storage provider 3PAR, and now Oracle has announced it will bring on former Hewlett-Packard CEO Mark Hurd as co-president to further Oracle's strategy of providing clients with more integration of software and hardware. ZDnet's Larry Dignan has some notable insights on that move in an article here.*

While these recent headline-grabbing maneuvers by the largest of the tech titans are notable for investors, and notable for their confirmation of the tectonic shifts we have been describing as important for investors to understand, we believe that it also provides an opportunity to make a larger point about investment philosophy.

We have always argued that investors should view investing as the allocation of capital to well-run businesses positioned in front of above-average growth opportunities. When we highlight major paradigm shifts such as the one described in the blog posts linked in the first paragraph, above, we do so in the context of pointing out that investors should be considering well-run companies that may be providing goods or services related to such opportunities.

While that may sound like common sense, there is actually a school of thought which argues that attempting to identify exceptional companies is just a gigantic waste of time. In fact, the proponents of this theory usually argue that it is worse than a waste of time -- it is a waste of money and a dead-end for investors. Some of them even argue that it is "anti-free market" and a form of denial that "markets work"!

We believe that the recent battle of the tech titans should help illustrate some vital points. HP and Dell got into a vicious bidding war over 3Par and drove its selling price to over $2 billion, upping Dell's initial bid of $18 a share all the way to $33 per share -- over 83%. Keep in mind that the 83% bidding escalation came on top of the initial Dell bid of $18, which was in itself about an 80% premium to the $10 price range in which the 3Par stock was moving before the initial offer.

Businesses don't throw money like that around just for the fun of it -- the tectonic shifts we have been pointing to in this blog are happening, and there are going to be winners and losers when these shifts take place. Companies both large and small are jockeying for survival. When the landscape is changing rapidly, companies that once absolutely dominated their respective kingdoms can find themselves toppled and overthrown. Those who have followed the changes in the computer world long enough will perhaps remember what happened to former heavyweights DEC, Wang, and Burroughs.

For a deeper understanding of these shifts, we would recommend George Gilder's important and far-sighted 1996 article in Wired magazine which we have discussed before, as well as the concepts articulated by thinkers such as Joseph Schumpeter.

The investment lesson we believe should be taken from this subject is quite different from the lesson that many mistakenly draw when they think about these matters. Often, we hear people argue along these lines: "that's why investors should buy all of those companies -- you just don't know who will win and who will lose -- I recommend a good tech sector fund, or ETF, or maybe just a broad index fund, for that very reason!"

Unfortunately, that argument is flawed, especially if you are talking about the larger-cap companies, which are the only ones with which most commentators in the financial media (and many representatives of the financial industry) are familiar.

We believe it is much wiser to search out and carefully research several smaller companies which are innovative, well-run, and positioned to take advantage of the new paradigm. If an investor buys five such companies and four of them don't pan out but one of them returns ten-fold, it can make up for the others.

On the other hand, if an investor buys five mature titans in a rapidly-changing industry, and three or four of them languish, dying a slow death over many years, the one or two winners will probably have little chance of growing five-fold or ten-fold. The most an investor can generally hope for in a giant mature company, even if it is a winner, is a double (there are, of course, exceptions). With such odds, it should be clear that the strategy many people advocate does not have much promise for the investor. We have articulated other problems with the "buy the entire sector" and the ETF approach in other previous posts as well (see for example here and here).

As an aside, in our first example we posit selecting five smaller companies and having only one succeed. It is our conviction that with reasonable research that looks at the right business criteria, it is possible to pick the winners and the losers -- not with perfect accuracy, but perhaps at a rate that is better than merely one in five.

We believe this is a very important principle, and one that doesn't just apply to the tech sector, but to all businesses in a free economy (remember that when Schumpeter was writing, he used illustrations from farming, with innovations such as crop rotations and tractors -- after all, he was born in 1883).

It should reinforce what we hope is the constant message of our blog -- that investors should think of investment as the allocation of their capital to businesses, and that they should spend most of their investment energies looking for good businesses positioned to add value in an ever-changing landscape that will necessarily have winners and losers.

* At the time of publication, the principals of Taylor Frigon Capital Management do not own securities issued by any of the companies mentioned above, including Dell (DELL), Hewlett-Packard (HPQ), 3Par (PAR), or Oracle (ORCL).

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Why do we want the Fed to steer the economy?

Recently at the annual economic conference in Jackson Hole, Fed Chairman Ben Bernanke said that the Fed "will do all that it can" to ensure an economic recovery, according to this Bloomberg story. The article then goes on to cite the reactions of various Wall Street economists, such as one who said, "The Fed is ready to take action as needed -- they realize the economy is not doing as well as expected."

Absent from the story were any opinions that the Fed should have nothing to do with steering the economy, and that such steering was a large part of what wrecked the economy in the first place (see our post from July of last year entitled "The Fed's oversteering and the wreckage of the past decade").

We believe that the Fed should focus on keeping a stable monetary policy, and that's it (we commend Mr. Bernanke for saying that the Fed would be vigilant in preventing either inflation or deflation, which is what the Fed is supposed to be doing). Economists such as Mr. Bernanke do not generally have experience running businesses, let alone running an entire economy. They should provide a stable currency, so that businesses can make decisions in a predictable monetary environment.

This metaphor of "steering the economy" is pretty popular right now, as evidenced by this recent story about President Obama's fondness for saying the Republicans drove the economy into a ditch and he and the Democrats have been sweating to get it back out. The Republicans want the keys back, he said, but "if your teenager drives into a ditch, your car, bangs it up, you've got to pay a lot of money to get it out, what do you do? You take the keys away [. . .] Our back is sore from pushing that car out of the ditch. And I mean, if they want to get in the back seat, that's OK. But we're not going to put them behind the wheel.”

Absent from the article describing the growing level of detail in the "car in the ditch" metaphor is the rather obvious question of "Why would you want the federal government to be 'driving' the economy in the first place?" The Constitution doesn't say anything about giving the federal government the responsibility of "driving the economy," whether it is being run by Republicans or Democrats or anyone else.

Prior to the Great Depression, people would have been shocked at the very idea that the federal government needed to "drive the economy" or that the president should be getting "down in the ditch" pushing the economy out whenever it gets stuck. Politicians may have experience in lots of things, but running economies (or pushing cars out of ditches) are usually not among those skills.

In fact, we have presented evidence in the past that government "stimulus" actually hurts economic growth, because it makes less capital available for those in the private sector who really drive the economy. So the next time you read that "the Fed" or "the government" stands ready to "do what it takes" to move the economy forward, you might ask yourself why we should want them to do that, and when that became their role.

Since the media does not seem to be asking those questions, we thought we would bring them to the attention of our readers.

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