November Investor Guide
Why companies should not fault a weakness in the market on their ability to grow
Understanding “The Greatest Retirement Crisis in American History”
What's the long-term prognosis and should you be concerned?
If you had a nickel for every executive who appeared on CNBC and blamed his or her company's inability to grow on a weakness in the market, you'd be richer than Croesus.
Of course, there's a reason this explanation for uninspiring performance is so common: It's readily available. At any given time, roughly half of all industries are growing below the level of GDP. And it's only natural to blame something external for one's problems.
But a weak market isn't a valid excuse. In "Growing When Your Industry Doesn't," in the Summer 2014 Strategy&Business, Strategy& partners Kasturi Rangan and Evan Hirsh point out that plenty of companies that achieve above-average shareholder returns compete in average or below-average industries.
If you're an executive in one of these industries, it's your job to ignore the excuses and figure out how to join the ranks of overachievers.
In their analysis of shareholder returns over the last few decades, Rangan and Hirsh found the phenomenon of superior performance to hold true in every industry, in every part of the world, and over every time period.
Between 2003 and 2013, for instance, 30 percent of companies with top-quartile shareholder returns were in industries growing at or below the rate of GDP. Even industries at the bottom of the heap produced their share of top performers.
How do the winners in low-growth industries do it? By taking market share from others. And by taking it profitably, often without reducing prices.
When companies get these two things going together — market share and profitability gains — they create their own growth cycle, one that is independent of the industry cycle. A sort of disequilibrium takes hold, allowing the companies that created it to become dominant in their sectors.
Equilibrium is the state that exists when companies with similar offerings compete within a market, getting similar returns and amassing market shares within a few points of one another. When markets are in equilibrium, players battle for minuscule amounts of market share.
Disequilibrium is much more dynamic. The companies that create the conditions for it generally don't follow a template, but discover a particular advantage they can use to tilt the market in their direction and keep it that way.
These enterprises often fascinate competitors because they offer proof that true advantage can be created and sustained for years when companies are especially shrewd — no matter the overall state of the industry.
Among the more vivid examples of how a company can introduce disequilibrium into its market — and earn above-market returns as a result — is Blockbuster Video. The company enjoyed a prolonged run of success in which it capitalized on a form of disequilibrium that it had managed to create.
Blockbuster entered the movie rental industry in the mid-1980s, when there were about 60,000 rental stores already in place. In a market that generally consisted of cramped, musty stores, with quirky selections and inventory prone to malfunctioning, Blockbuster stood out. Its retail spaces were well organized, with wide selections that featured hundreds of new titles. Blockbuster was big enough to gain scale advantages — including in what it paid for its inventory.
Blockbuster's superior model allowed the company to wrest existing customers from many smaller stores, and to pull in a fresh set of customers just entering the market. By 1990, the aggregate dollar value of movies rented and watched on home VCRs had essentially reached its market peak and was flattening out.
Yet in this slow-growing market, Blockbuster thrived. Its share grew from 10 percent in 1990, to 35 percent in 1995, to 45 percent in 2000.
Blockbuster created disequilibrium in one of the two ways it can be done, through changes on the supply side of the market. Supply-side changes that push a market in one company's favor usually involve advantages in quality, functionality, cost/price, service, or selection. Blockbuster had the last three of these in abundance.
The other way to create disequilibrium is through changes that capture demand that didn't previously exist. Demand-side changes are typically enabled by some sort of technology shift or by new regulations. Executives who want to create disequilibrium should begin by asking themselves a few questions:
Some degree of disequilibrium, created by a company with a clear source of advantage at a given moment, is actually quite common. But usually it doesn't last.
Only when market leaders take steps to deepen and extend whatever is working for them can they sustain their advantage. And then companies can sometimes hold on for decades, continuing to grow even when their industry is static or shrinking.
Companies in the lead typically have two important levers available to them.
The stories of market leaders Netflix and Johnson Controls Inc., or JCI, which we'll come to shortly, help illustrate the power of these tactics.
The success of a leading company's business always spurs competition, from the existing rivals and, often, from new entrants. If the competition doesn't offer anything new, the leader will hold on to most of its market share or even gain more share.
But if a rival comes up with a superior approach, the disequilibrium dissolves.
Here we can resume the Blockbuster story line: Starting in the mid-1990s, the company's success attracted two new players, Hollywood Video and Movie Gallery, both of which were largely copying Blockbuster's model of running well-organized video stores nationally. But the new entrants did not offer enough differentiation to overcome the disequilibrium Blockbuster had created.
The turning point came in late 1999, with the emergence of Netflix. With its model of allowing consumers to order DVDs online and receive them by mail a few days later, Netflix tapped into an appetite for online shopping and convenience that was just beginning to take shape.
For the first time, Blockbuster found itself behind a trend instead of initiating one. Things only got worse in 2007, when Netflix began making movies available to its customers via streaming technology.
Blockbuster had no answer to the value proposition of streamed video entertainment. It wasn't long before its greatest assets, its physical spaces, were becoming a huge liability and a drain on the company's cash and capital.
In 2010, having failed to evolve its decades-old business model, Blockbuster filed for bankruptcy. It closed its last stores in January 2014.
For the better part of the past decade, Netflix has been taking advantage of disequilibrium. Looking at the company's performance, including a subscriber base and revenues that rose by more than 250 percent between 2009 and 2013, you might think that home video rental is a sweet place to be.
But for most companies, it isn't. It's just that Netflix built the position and made the investments needed to get a good share, then a better share, then a huge share, of a slow-growing business. Netflix's recent talk of raising prices shows it understands the power it has and is looking for additional ways to capitalize on it.
Netflix's determination to double down and keep getting better at the things that set it apart is a lesson for every company. In fact, it demonstrates a path to winning that's more reliable in low-growth industries.
In those industries, external shocks, whether from technology or regulatory change, are less common, so companies have a better chance of maintaining their advantage for extended periods of time. Also, they can often turn internal operations and process innovations into sources of competitive advantage, continually improving in those areas and upping the ante for rivals.
Consider JCI's energy storage business, known as Power Solutions. Batteries have been a slow-growth industry for decades. In the early 1990s, after losing Sears, its biggest customer, the division struggled.
The unit's leaders realized they had to make some fundamental changes. They launched a major restructuring program, attacking inefficiencies of every type. The resulting 25 percent cost reduction allowed the business to survive, and, gradually, to become stronger.
Through a relentless focus on continuous cost improvement and through critical investments in advanced process technology, JCI's battery business transformed itself into the industry front-runner. The company was able, over time, to offer better prices than most of its rivals. This allowed it to build back a sizable U.S. market share.
Pre-tax operating profit in the Power Solutions business unit has grown 17 percent annually for the past decade — a remarkable achievement in a slow-growth industry. Market share increases have been a big contributor to the unit's stellar profit performance.
So has the company's low cost basis, which has helped create a situation in which increased customer demand and economic gains benefit JCI's bottom line and further strengthen its position.
What does all this mean, if you're a CEO in a slow-growing industry? It means you shouldn't go looking for a "better" industry, one that's growing more rapidly than yours.
Embrace your own segment. The opportunity to get great returns is probably better where you are than in a market that's growing by double digits.
You can make those better returns come to you by figuring out where you have an advantage, or might gain one, in terms of cost, service, selection, or a disruptive new product. Make an increase in market share your main measure of winning.
Finally, once you've got the advantage, keep on doing what you need to do to extend it. The nature of any market is that the opportunity is finite.
Are You Ready for the Greatest Retirement Crisis in American History?
According to a recent headline in Forbes, the nation is facing "The Greatest Retirement Crisis in American History." The article predicts, "In the decades to come, we will witness millions of elderly Americans, the Baby Boomers and others, slipping into poverty. Too frail to work, too poor to retire will become the ‘new normal' for many elderly Americans. . . . [A] catastrophic outcome for at least a significant percentage of our elderly population is inevitable. With the average 401(k) balance for 65-year-olds estimated at $25,000 by independent experts—$100,000 if you believe the retirement planning industry—the decades many elders will spend in forced or elected ‘retirement' will be grim."
Several studies and surveys support this dire conclusion:
The reasons for this so-called "crisis" seem logical:
Americans are living longer thanks to advances in healthcare, lifestyle changes due to greater awareness of the risks of smoking, and improvements in automobile safety that have reduced traffic fatalities.
At the same time, Americans are saving less because of job losses during the recession, stratospheric college tuition costs for their children, and the housing crash that decreased the value of their homes.
Most companies have eliminated pension plans, while the nation's Social Security system is underfunded.
It all makes for a compelling story, but how much of it is true? If we look more closely at the arguments for the retirement crisis, we find two major fallacies:
In fact, Andrew G. Biggs and Sylvester Schieber discovered these same problems in recent studies and articles about the retirement crisis. Biggs is a former principal deputy commissioner of the Social Security Administration. Schieber is a former chairman of the Social Security Advisory Board. They detailed their findings recently in National Affairs.
Let's expose each of these fallacies.
The first concerns how much income retirees will need.
Ironically, much of the anxiety about the future has been created by the Social Security Administration, which theoretically was supposed to make Americans feel less worried about their retirement years. A widely quoted statement that appears in SSA publications declares that "Most financial advisors say you'll need about 70 percent of your pre-retirement earnings to comfortably maintain your pre-retirement standard of living. If you have average earnings, your Social Security retirement benefits will replace only about 40 percent."
It's easy to see why such a statement would set off alarms. But the statement is wrong, because it juxtaposes two percentages that are derived in different ways.
As Biggs and Schieber point out, financial advisors measure replacement rates based on final earnings; the first year of retirement income is calculated as a percentage of the last year of working income. By contrast, the SSA measures replacement rates based on the wage-indexed average of lifetime earnings.
What's the difference? Using wage indexing, the SSA increases past earnings years to account for the growth of average wages in the economy. So, if someone retires at age 65 this year and earned $200,000 in 1985, that 1985 salary was worth $436,400 in 2014 inflation-adjusted dollars. However, the SSA wage indexes the $200,000 to reflect the growth of the economy, which leads to a value of $532,810.
The financial planners' rule of thumb about replacing 70 percent of income is based on the salary of $436,400 in this example, or $305,480. But the SSA mistakenly suggests that retirees will need 70 percent of the wage-adjusted salary of $532,810, or $372,967. That's a difference of more than $67,000.
Biggs and Schieber were able to use publicly available data to compare the replacement rates Social Security actually pays versus the 70 percent rule of thumb used by financial advisors. The SSA's Benefits and Earnings Public-Use File includes thousands of taxpayers' work histories from SSA's databases, along with the benefits received by each individual.
The data reveal that the typical long-term worker receives a Social Security benefit equal to about 62 percent of his final earnings. This is defined as the average of non-zero earnings in the five years prior to claiming Social Security benefits.
People who earn lower incomes receive benefits at a higher replacement rate. The benefits that a long-term worker in the third earnings decile would receive would equal a replacement rate of 75 percent of final earnings.
The second misunderstanding concerns how much income retirees will receive from retirement savings.
The warnings about the retirement crisis are based on estimates of retirement savings that are inadequate. For most Americans, retirement savings take the form of employer-sponsored 401(k) plans and individual retirement accounts.
According to the Social Security Administration's most recent "Income of the Population 55 or Older" report, only 39 percent of people aged 65 or older receive pensions, with those pensions accounting for a mere 17 percent of retirees' total income.4 If those figures are to be believed, then most people are not financially prepared for retirement.
However, those figures are not credible. The data is based on the Census Bureau's Current Population Survey, which does not include almost all of the income that retirees receive from 401(k)s and IRAs. The Current Population Survey only counts pension benefits as income if they are paid on a regular basis.
This definition of retirement income means that a monthly benefit check from a traditional pension is considered income. But if retirees make an occasional, as-needed withdrawal from an IRA or 401(k), the way most people use such accounts, the money is not counted as income.
How much income isn't being counted? To get an answer, Biggs and Schieber looked at Internal Revenue Service data. Because most withdrawals from IRAs and 401(k)s are taxable, they must be reported to the IRS.
Social Security beneficiaries reported $111 billion in IRA withdrawals to the IRS in 2008. But using the very narrow definition of the Current Population Survey, the SSA only counted $5.6 billion in income from IRAs by people receiving Social Security benefits. In other words, it ignored 95 percent of the withdrawals that were reported to the IRS.
That's not all. The SSA reported that households receiving Social Security collected $200 billion in employer pensions and annuities. But those households reported $457 billion in such income to the IRS. So the SSA ignored 56 percent of pension income.
Looking ahead, The Strategic Wealth Advisor Editors offer the following forecasts based on this evidence:
First, the "retirement crisis" will not be as big of an issue as most Americans have been led to believe.
As we have discussed, the amount of income that retirees will need has been overestimated. At the same time, the amount of pension income they will receive has been underestimated. This appears to explain why, according to a study by Ohio State University economist Jason Seligman, two-thirds of current retirees say they are "very satisfied" in retirement, with another 25 percent "moderately satisfied," and only 14 percent saying that their retirement years are "not as good" as the years before they retired. In addition, RAND economists Michael Hurd and Susann Rohwedder found that most retirees end up with higher incomes than they had anticipated, noting, "If anything, households seem to be pleasantly surprised by their level of resources" in retirement.
Second, even for those who are genuinely unprepared for retirement, the problem can be readily solved with accelerated economic growth and some common sense entitlement reforms.
We need to raise the retirement age, create more incentives for people to save, and clean up the Social Security Disability system. For individuals, the solution will be to work longer and save more. But as a nation, the economic activity growing out of the Deployment Phase of the Fifth Techno-Economic Revolution, outlined in previous issues of our sister publication Trends, will provide a rising tide of prosperity that will "lift all boats." The blossoming North America Energy Revolution represents the first step in that resurgence.
Third, knee-jerk policy responses based on the misleading SSA data will turn out to be exactly the wrong moves.
For example, Iowa Senator Tom Harkin has proposed eliminating the $117,000 cap on the Social Security tax in order to generate more revenue for the program. But taking resources away from top earners is one of the best ways to ensure prolonged economic stagnation, which would make accelerated growth that much harder.
The 2014 housing market is going through a complex and contradictory transitional phase as it recovers from the biggest cataclysm to hit the sector since at least the Great Depression. The growth surge of 2013, which was driven by pent-up demand, has given way to a market characterized by six incompatible subtrends:
It's unclear at the moment what combination of these subtends will prevail. To understand what's going on, let's examine each subtrend in turn, starting with the shortage of sellers and existing homes for sale.
As of May 1, 2014, there was a very limited supply of homes from which potential buyers could choose. Specifically, there was a five-month inventory of homes on the market, compared with 5.9 months in 2012 and 8.3 months in 2011. The housing supply last dipped toward the five-month level at the height of the boom in 2006, when buyers snapped up homes faster than they could be added.
Existing Home: Year-Over-Year Inventory
This time, fewer homes are being listed because 19 percent of owners are underwater on their mortgages—meaning the sale price wouldn't be enough to repay their loan. Furthermore, the extreme winter that ended in early March prevented many in the Midwest and on the East Coast from listing their homes in recent months.
When few sellers emerged last year, prices for the limited number of homes available surged. Would-be buyers, facing a shortage of homes and locked in competition with one another, raised their offers. In a recent Associated Press story, the CEO of Redfin was quoted as saying that "60 percent of [our] buyers faced bidding wars in February, down from 73 percent at this time last year."
Prices climbed in locales such as San Francisco, where a ton of money is chasing few properties and there's not enough construction. On average, Bay Area homes have surged 23 percent over the past 12 months, according to the S&P Case-Shiller index. That was faster than any other major metro area except Las Vegas, where much of the housing stock was rebounding from the depths of the recession.
But while supply problems limit activity in the broader markets, the bottom of the market is plagued by a serious shortage of first-time buyers. This is the second subtrend influencing the U.S. housing market.
The demographic context discussed earlier in this issue is playing a major role. After the Great Recession officially ended in mid-2009, economists predicted that pent-up demand for homes would drive sales in the years to come.
Unfortunately, this demand has been slow to materialize, especially at the bottom. Therefore, the "domino effect"—which usually starts with 20-somethings buying so-called "starter homes" and often ends with retired professionals selling multimillion-dollar mansions—is not working as it should.
Five years into the recovery, buying remains subpar. Sales of existing homes are projected to total 5 million in 2014, according to the National Association of Realtors. That's roughly 100,000 fewer sales than 2013 and about 10 percent below the 5.5 million needed for a healthy housing market.
What happened to the first-time buyers? They bought about 1.5 million homes last year, about 500,000 fewer on average than should be expected given the number of young adults and the number of renters.
According to Trulia, the price increases we saw in 2013 made affordability a larger obstacle for potential first-timer buyers. Unlike current owners whose down payments come from selling a previous home, first-timers must amass a down payment. That means that higher home prices require more cash upfront.
Whether it's raising the down payment for a first-time purchase or a current homeowner qualifying for a mortgage on a new house, the recent loosening of lending standards represents the third major subtrend impacting the U.S. housing market.
After the economic meltdown began in 2008, people with middling-to-weak credit found it very difficult to qualify for mortgages. However, it's fair to argue that something resembling "subprime borrowing" has recently emerged.
Consider the facts. The median credit score for 30-year fixed mortgages had been around 730. Yet, according to the Associated Press, Wells Fargo is now offering mortgages to subprime borrowers with credit scores as low as 600, down from 640.
Similarly, non-bank lenders such as Carrington Mortgage Services are moving into that territory. Carrington has dropped its minimum credit score to 550. These examples indicate that lenders are becoming less tight-fisted after restricting credit in the wake of the financial crisis.
Why is this happening? Lenders are hungry for more business after mortgage refinancing plunged in the past year as interest rates rose. The average 30-year fixed mortgage rate has risen about a percentage point to 4.4 percent from near-historic lows in May. Meanwhile, a subprime borrower with a credit score of 550 would pay 7.15 percent, according to Carrington's rate sheet.
The fourth subtrend is the disappearance of cash-only investors. The Strategic Wealth Advisors editors have repeatedly called attention to the huge opportunity for those who invested in buy-to-rent homes that emerged beginning in 2010. According to the National Association of Realtors, in 2013, 20 percent of home sales were made to investors rather than traditional homeowners.
Most of these investors made all-cash offers and ignited bidding wars that other would-be homeowners lost. Typically, investors bought properties as rehab projects or rentals.
Areas that suffered the most during the recession's housing bust, including Phoenix, Las Vegas, and Tampa, have been the favorites of investors and have seen prices rise most strongly in percentage terms.
As a result, they're no longer the bargains that investors found them to be in 2010, 2011, 2012, and 2013. The result is that bidding wars aren't likely to be as fierce in 2014.
The fifth subtrend is the relative popularity of high-end properties vs. middle and low-end homes. For the moment, it's clearly better for sellers at the luxury end of the real-estate spectrum. Prices have generally been rising faster than at the lower end, and buying activity has continued to increase over the past year.
U.S. Medium New Home Sales Prices vs Medium Household Income
U.S. Median New Home Sale Prices vs. Median Household Income
Sales of homes worth more than $1 million rose 14.4 percent over the past 12 months, according to Bank of America Merrill Lynch. By contrast, sales of properties valued at less than $100,000 dropped 18 percent. A key reason: Fewer foreclosed homes are being listed.
According to Zillow, prices for more expensive homes have also risen much faster. The firm divided the U.S. housing stock into thirds based on price. The top one-third of the market, now valued at $305,700 or more, rose in value annually at a 3.38 percent average during the past 18 months. That price growth was 20 percent faster than the price rise seen by the bottom two-thirds of the market.
Essentially, it's a two-tiered market: Top-tier homeowners are enjoying a substantially better market than are the owners of bottom-tier homes.
That brings us to our sixth subtrend, the decoupling of personal incomes from housing prices.
Some have argued that the rapid rise in home prices during the housing bubble was the result of this decoupling. More important, they contend that the inflation of the housing bubble of 2001 to 2005 is now repeating. The message from those quarters is that we need to be ready for another housing crisis in the decade ahead.
Given these six subtrends driving the housing market, the editors of Strategic Wealth Advisor make the following forecasts for your consideration:
First, the shortage of homes for sale is likely to be reduced in 2014 and 2015, as prices reach levels that sellers consider enticing.
As always, supply problems will correct themselves. Higher prices will lure more sellers into the market who see an opportunity to cash out. About 19 percent of homeowners owe more on their mortgages than their properties would sell for, according to the online real estate database Zillow. An additional 37 percent are "effectively underwater": Their sale profit would be too low to cover the cost of listing their home and putting a down payment on a new property. Still, each mortgage payment repairs some of the damage and improves a homeowner's equity. As home values grow further, more people will start to put their homes up for sale, and the supply should rise. That would lead to more listings and reduce bidding wars among buyers. Warmer weather, job growth, and a strengthening economy will also encourage more listings.
Second, we'll see a rise in first-time home buyers as the economy improves, but a major surge will not take place before 2017 or 2018.
The situation is slowly improving for the 25- to 34-year-olds who would buy homes. About 738,000 of them found jobs in the past year. With more disposable income, more of them will move out on their own. Homebuilders have already ramped up apartment construction in anticipation of younger renters. That's a critical first step before they eventually buy a house or condo. It will take years for these young adults to accumulate the savings and credit history needed to buy a home.
Third, lenders will continue to loosen standards in the medium term, but this will not lead to a catastrophic blow-up.
Loosening standards will permit many younger people to become homeowners and start the crucial domino effect that leads to a healthy economy. This time around, memories of the "housing crash" are fresh in the minds of lenders, borrowers, and regulators; these will prevent the worst excesses from repeating themselves. Moreover, as the Strategic Wealth Advisor editors have argued since the fall of 2008, the difference between the moderate 1991 recession and the existential crisis of 2008 to 2009 was primarily the result of mark-to-market accounting rules that no longer apply.
Fourth, investors will continue to buy rental properties, but their 20 percent share of total transaction value in 2013 represented a peak.
As the result of surging rents, Trulia now reports that there is no major U.S. market where it's cheaper to rent than to own. However, would-be first-time buyers, saddled with student loan debt and a precarious employment situation, are either unwilling or unable to buy. This means a steadily growing rental market waiting to be exploited by shrewd investors. That dynamic is on display in places like Cincinnati, where home prices only rose an average of 2 percent in 2013, while rental rates jumped 10 percent. With bond yields expected to remain low, investors have a choice between rental property and equities; for those seeking income as much or more than capital gains, the rental property option will continue to be attractive for at least another three to five years.
Nation Wide Cheaper to Rent
Fifth, the market for high-end homes will continue to be stronger than the market for low-end homes, for at least the next five years.
As we have previously detailed, wealth currently belongs to the Boomers, the Silent Generation, and the remaining members of the Greatest Generation. Fed policy and tax policy have been tuned to maximize after-tax investment income, rather than employment income. Since people with wealth are most likely to buy expensive homes, those are the homes that will sell. Even when affluent retirees "downsize," they frequently buy expensive condominiums or cottages in exotic locations. Fortunately, as the Deployment phase of the Digital Revolution and the accompanying North American Energy Revolution kicks in, broad-based economic gains will reenergize housing across the spectrum. We're already seeing this in places like North Dakota and Texas.
Sixth, the apparent decoupling between median household incomes and median new home prices is nothing to be concerned about.
When one looks at nominal incomes and new home prices over the past 46 years, there's an excellent linear relationship between them from 1967 to 2000, at which point that relationship appears to break down, as prices soar. However, when real inflation-adjusted prices and incomes are used, that apparent correlation is shown to be a mathematical fiction. On the contrary, real home prices have risen primarily as a function of larger home size. Meanwhile, real median household income has fluctuated as a function of short-term economic fluctuations, coupled with the changed composition of the median household. So, the Strategic Wealth Advisor editors believe that this is simply "much ado about nothing."