John Mauldin's Outside the Box : Economy, Cisco

America’s Greatest Wealth Creation Engine

John Mauldin — Mon, 30 Aug 2010 22:08:00 GMT

Those who know me well know that I am in incurable optimist. I think the world is going to be better in ten years than it is today. I thought that 20 years ago and 10 years ago and expect to think that 10 years from now. Part of that reasoning comes from the accelerating pace of change in the technology world. The next 10 years will see more change than the last 20-30 years combined!

And that means opportunity. Yes, with ups and downs and twists, but opportunity nonetheless.

This week’s Outside the Box is a short essay from my friend Alex Daley who writes the letter Casey’s Extraordinary Technology. I have had the pleasure of spending time and corresponding with Alex, and he is one of the smartest guys I have ever met. Alex had a VERY senior position at Microsoft and has a serious range of experience. In his varied career, he has worked as a senior research executive, a software developer, project manager, senior IT executive, and technology marketer. Aside from his technological prowess, Alex has been involved in numerous startups as an advisor to venture capital companies and a successful angel investor in his own right, with a long history of spectacular investment successes. Every month, he analyzes and recommends the best tech stocks to get in now – from biotech firms to cyber-security providers with innovative solutions.

You can get a free trial subscription to his letter, which I find very valuable in keeping me up to date on what is going on as well as providing some direction (his portfolio has done well!). Click on the link if you are interested. Read more here.

Your paying attention to tech analyst.

John Mauldin

America’s Greatest Wealth Creation Engine

by Alex Daley and Doug Hornig

To judge by the headlines, you might think we Americans have lost the ability to create wealth.

The stock market is floundering, even after flatlining for a decade. The overall economy is in the doldrums. Domestic heavy industry has all but disappeared. Real estate has crashed. The airlines, the automakers, the banks, all have gone to Washington, begging bowl in hand, demanding handouts from a government that, like the average citizen, is drowning in debt.

Bad news abounds, no doubt. Yet, amid all the doom and gloom, it’s easy to overlook the fact that the real engine of growth in the modern world is chugging right along.

Easy because many investors have turned their attention intently in the direction of interest rates and housing starts and the pontifications of Ben Bernanke, failing to notice that one of the markets they left behind is now leaving them behind.

Over the past decade, while the overall market was weakly limping along, these companies have been steadily growing revenues, adding jobs, and spewing profits. At the same time as brash startups were reinventing news, entertainment, communication, medicine, and virtually every other aspect of our work and home lives, promising to deliver still more growth even in this weak economy.

We’re talking about technology, of course.

Technological development is impersonal and implacable. It cares not who controls Congress or chairs the Fed. It has been the stuff of American life for a century – from the assembly line to the smartphone. Most importantly, it’s done what a successful segment of the economy is supposed to do, bring about prosperity by adding to the tangible wealth of the country.

And it did so the old-fashioned way, by creating things useful to society.

It made money for the innovators who were able to parlay their intellectual property into products that people wanted to buy. It made money for the people who worked for the innovators. It made money for companies, and their employees, that increased efficiency by integrating technological advances into their businesses. And it made money for investors who backed the leading lights in the field.

Tech, in short, has not only raised everyone’s standard of living, it has created wealth. Lots of wealth. And it continues to do so today, right through all of our economic turmoil.

One incredibly simple measure of the prosperity created is market capitalization, the sum total of the wealth held by investors.

Thirty years ago, in 1980, the entire stock market boasted only three mega-companies, i.e., those with market caps in excess of $40 billion (the equivalent of $100 billion today, in inflation-adjusted dollars): Exxon, IBM, AT&T.

Those three are still with us, and all still boast $100B+ caps. But they are joined by no fewer than 21 other U.S. companies. Taken together, the 24 have a collective market cap of $3.8 trillion.

Technology allowed this to happen.

Consider that in 1980, five of the top 24 – Apple (#2), Microsoft (3), Cisco (15), Google (19), and Oracle (23), tech companies all – either hadn’t gone public or didn’t even exist.

Intel (21) was around, but almost no one had noticed. IBM (7) was an industry leader then, but only as the primary maker of clunky mainframes. Hewlett-Packard (24) had yet to introduce either inkjet or laser printers. Walmart (4) was still dreaming of the ultra-efficient, automated distribution system that would transform its business.

The contrast between the old and the new could not be more stark.

From the 1980s to today, General Motors has slid steadily downward, racking up billions in losses that culminated in a painful bankruptcy/bailout. Over the same period, a handful of geeks from Seattle grew their dorm-room startup, Microsoft, into a global software empire with over $60 billion per year in revenue. Along the way, the company turned four employees into billionaires and an estimated 12,000 into millionaires, while amassing some $250 billion in equity for shareholders.

In 1990, Countrywide Credit emerged as the nation’s leading mortgage banker. That same year, networking company Cisco Systems went public at a split-adjusted $0.08 per share and helped to usher in the Internet age with its routers and switches. Countrywide disappeared into Bank of America in 2008, after its credit rating was slashed to “junk” by Standard & Poor’s; Cisco now employs over 65,000 people and has created over $120 billion in market value.

Over the past 10 years, the airlines posted loss after loss, received numerous government bailouts, and saw the XAL airline stock index fall from 175 to 35, erasing billions in shareholder value. Meanwhile, a little Silicon Valley firm with a rather silly name, Google, built a $25 billion a year advertising behemoth and rocketed its market cap to over $140 billion.

And the list goes on.

Dell computers are still widely known for their “Dude, you’re getting a Dell!” ad campaign, but it’s been more like, “Dude you’re getting $23 billion since your 1988 coming-out party!” Global electronic storage leader EMC has gone from a tiny outfit when it went public in 1986 to $37 billion today. And that’s not including its subsidiary VMware, spun off on its own and now valued at some $25 billion. Since 2000, biotechnology leader Celgene has added over $20 billion in wealth to its shareholders’ pockets.

It isn’t just the behemoths, either. Smaller companies across the industry, and straight through America’s supposed lost decade, have granted themselves licenses to print money. Since its 2002 IPO, for example, Netflix has built up a $5.6 billion market cap. Computer graphics chip maker NVIDIA has conjured $5.8 billion in new wealth since its 1999 public debut. Boating equipment supplier Garmin reinvented itself last decade through GPS navigation systems, to the tune of $5.8 billion.

Even today, as we struggle through what many have labeled the next great depression, technology keeps on creating fortunes. Founded in 2000 and IPO’d in 2009, restaurant software pioneer OpenTable has put on weight to the tune of nearly $1 billion in market cap and is still growing furiously. Network security outfit Fortinet, also founded in the doldrums of 2000 and taken public just last year, has secured some $1.1 billion for its shareholders and the fast-growing new market it created.

Sure, the easy-money days were 1980-2000, when the tech-heavy NASDAQ Index soared from around 160 to 4,700. That’s a stunning compound annual growth rate of 18.5% for 20 years. If you managed to ride the wave trough to peak, every dollar you threw at the NASDAQ turned into 30. And the beauty of it was, you didn’t have to know silicon from soy sauce. You could have put your investment cash into almost anything.

No longer. In 2000, the balloon popped. The dotcom bust slammed into the market, the economy went into recession, and the era of indiscriminate investing came to an abrupt and well-deserved end. The NASDAQ Index remains at just about half the high-water mark established ten years ago.

Small wonder so many have lost all faith in technology.

Which is too bad. Because technology is an unstoppable force. It doesn’t grind to a halt, or even slow down, just because it falls out of favor on Wall Street. Inventors continue to innovate, entrepreneurs continue to market the resultant products, and consumers continue to buy.

Moreover, although the train has been rolling right along, it’s far from too late to get on board. Savvy tech investors may have to put in the time and effort to sort the good companies from the bad this time around, thankfully. But there are more opportunities than ever to use the sector to build personal wealth.

Some look at technology and see only the downsides. The oil spills, the loss of privacy, the ugly machinery of war. But we recognize that technological advances have, for the most part, made our lives longer, better, healthier, more comfortable, and more fun. There’s no reason to believe that that trend won’t continue. In fact, the biotech and nanotech revolutions now just getting underway promise to usher in a renaissance of such magnitude that it will likely make all our previous techno-magic seem like simple card tricks. (Although we will need to refrain from blowing ourselves up in the interim.)

So the answer to the original question is: no, we haven’t lost our ability to create wealth. At least not in one critical area for the future. And with every conceivable measure showing the rate of technological change increasing exponentially, we have accelerated it.

Looking ahead, the eightfold increase in mega-caps since 1980 is likely to seem paltry thirty years from now. More foreigners will enter the ranks; many more, since China and India presently contribute fewer than two dozen to the world’s 500 largest companies. And it’s dead certain that the market leaders in 2040 will include many firms that today are no more than a gleam in a high schooler’s eye.

As an investor, cashing in on the tech boom of the past three decades has meant finding the most promising young companies at the beginning of their trip skyward. That will also be the case in the next three.

Only the names will change.

The Importance of Start-ups

John Mauldin — Mon, 23 Aug 2010 19:22:00 GMT

Which Are We Going To Bet On?

I knew I would be touching a raw nerve with my last two posts, on patents. But I was really surprised at the divergence of opinion. Entrepreneurs overwhelmingly supported my stance that software patents hamper innovation and need to be abolished, but friends at Microsoft, IBM, and Google were outraged at my recommendation. The big companies’ executives argued that abolishing patents would hurt their ability to innovate and thus hamper the nation’s economic growth. (They believe that companies like theirs create the majority of jobs and innovations, and they claim that without patents they cannot defend their innovations.) I am not convinced that software patents give Google any advantage over Microsoft and Yahoo, or make IBM’s databases any better than Oracle’s. But I do know one thing for sure: it isn’t the big companies that create the jobs or the revolutionary technology innovations: it is startups. So if we need to pick sides, I vote for the startups.

Let’s start with the question of who creates the jobs. This is one of the issues that I recently took Intel co-founder Andy Grove to task for, in BusinessWeek. Grove wrote a profound essay lamenting the loss of American manufacturing jobs. I share his concerns about jobs. But Andy’s protectionist recommendations for restoring America’s competitiveness were largely based on his flawed premise that companies like Intel create all the jobs—not the startups. I also discussed the tradeoff between bailing out companies like General Motors, AIG, and Citibank and nurturing startups in this BusinessWeek piece. This question is more important than it may seem.

Kauffman Foundation has done extensive research on job creation. Kauffman Senior Fellow Tim Kane analyzed a new data set from the U.S. government, called Business Dynamics Statistics, which provides details about the age and employment of businesses started in the U.S. since 1977. What this showed was that startups aren’t just an important contributor to job growth: they’re the only thing. Without startups, there would be no net job growth in the U.S. economy. From 1977 to 2005, existing companies were net job destroyers, losing 1 million net jobs per year. In contrast, new businesses in their first year added an average of 3 million jobs annually.

When analyzed by company age, the data are even more startling. Gross job creation at startups averaged more than 3 million jobs per year during 1992–2005, four times as high as any other yearly age group. Existing firms in all year groups have gross job losses that are larger than gross job gains.

Half of the startups go out of business within five years; but overall they are still the ones that lead the charge in employment creation. Kauffman Foundation analyzed the average employment of all firms as they age from year zero (birth) to year five. When a given cohort of startups reaches age five, its employment level is 80 percent of what it was when it began. In 2000, for example, startups created 3,099,639 jobs. By 2005, the surviving firms had a total employment of 2,412,410, or about 78 percent of the number of jobs that existed when these firms were born.

So we can’t count on the Intels or Microsofts to create employment: we need the entrepreneurs. And there is an important lesson here for the states and cities that offer huge incentives to companies like Dell, Google, and Intel to locate their operations there. The regions should, instead, be focusing on creating more startups, not providing life support to technology behemoths.

Now let’s talk about innovation. Apple is the poster child for tech innovation; it releases one groundbreaking product after another. But let’s get beyond Apple. I challenge you to name another tech company that innovates like Apple—with game-changing technologies like the iPod, iTunes, iPhone, and iPad. Google certainly doesn’t fit the bill—after its original search engine and ad platform, it hasn’t invented anything earth shattering. Yes, Google did develop a nice email system and some mapping software, but these were incremental innovations. For that matter, what earth-shattering products have IBM, HP, Microsoft, Oracle, or Cisco produced in recent times? These companies constantly acquire startups and take advantage of their own size and distribution channels to scale up the innovations they have purchased. They let the startups take the risk and prove the business models.

This raises an interesting question. Google and Microsoft have always prided themselves for hiring the cream of the crop of software developers. It is ridiculously hard to get a job at either company. But when technology’s top guns join these companies, they seem to make a smaller impact than those that don’t get hired. So would these companies be better served by releasing their most brilliant developers into the wild and arming them with seed financing to start companies? (They could negotiate partial ownership and right of first refusal on acquisition.) We would certainly get more innovation this way.

Simply put, if we are serious about lifting the economy out of its rut, we need to focus all of our energy on helping entrepreneurs. Provide them with the incentives (tax breaks and seed financing); education; and infrastructure. And gear public policy—like patent-protection laws—toward the startups. Let’s not bet on the companies that are too big to fail or too clumsy to innovate.

Editor’s note: Guest writer Vivek Wadhwa is an entrepreneur turned academic. He is a Visiting Scholar at the School of Information at UC-Berkeley, Senior Research Associate at Harvard Law School and Director of Research at the Center for Entrepreneurship and Research Commercialization at Duke University. You can follow him on Twitter at @vwadhwa and find his research at www.wadhwa.com.

When Did Thrift Become Bad?

By William C. Dunkelberg, Chief Economist

National Federation of Independent Business

Supporters of letting the “Bush tax cuts” expire, especially for those with incomes over $200,000 (the “rich”), argue that money given to the rich is mostly “saved” while money to the “poor” is spent 100%, thus stimulating the economy. We can infer from that position that the argument is that “savings” don't matter for the economy or that the rich somehow destroy the income they do not spend (i.e. save) and it has no impact on the economy. A Brookings report (August, 2010) reports “…most Bush tax cut dollars go to higher-income households and these top earners don't spend as much of their income as lower earners”. So, economic policy is to take money from the successful and savers and give it to those who will spend spend spend?

Savings is defined as “non-consumption”, if you don’t spend it (on government or personal consumption), it is saved, whether in your mattress, or in an insurance premium, or buying stocks and bonds or putting the money in a bank. Savings make up the pool of funds we use to finance “investment”, the creation of new productive assets like equipment, office or warehouse buildings, inventions, new vehicles for business purposes, things that raise worker productivity and income in the long haul.

If you don’t put money in the local bank (i.e. save and deploy the funds in the financial system somewhere), we can’t finance any of these investment expenditures. It’s that simple. We are already a nation of poor savers, with our consumer saving rate reaching near zero in the housing boom (p.s. new housing is counted as investment, a new asset, but it doesn’t have much impact on productivity). So, the notion that rich people waste their incomes by saving a significant percentage of it is so off the mark! We need savers, and policies that transfer income earned by the successful to those who will spend 100% of it and don’t save anything is a recipe for economic disaster.

Most small businesses when started are financed almost entirely with the savings of the entrepreneur and small firms grow and create jobs with earnings that are “saved and re-invested” in the firm. The Brookings report argues that ending the cuts will have minimal impact on small business growth because “Less than 2 percent of tax returns reporting small-business income are filed by taxpayers in the top two income brackets”. This “2 percent” number uses as a denominator about 29 million tax returns with schedule C business income. But most of these employ nobody, many are part-time businesses. There are only 6 million employer firms, 90 percent with fewer than 20 employees. These are the job creators and far more of them would be impacted by the expiration of the Bush tax cuts.

We have borrowed the savings of the rest of the world for years so that we could “party” and still invest in some real capital at the same time. The problem is that those lending us their savings reap the returns, not Americans, and eventually might expect to be repaid. Every time we go through these cycles, we pile on more and more debt which claims more earnings each year from investments financed by the debt (and by foreign direct and financial investment) and increases the total amount of debt that must be refinanced and repaid in the future. The longer we put off making governments and firms seeking subsidies accountable, the more devastating will be the day of “settlement”. And we all know it will come. Each “crisis” brings the day of reckoning closer.