Transformative innovation creates an explosion of new businesses followed by a surge of extinctions. Picking the winners is hard.
Warren Buffett tried to teach this lesson to a group of business leaders in 1999. To say it was well received would be an understatement.
None of the new Dot-com royalty cared to listen to an old man, out of touch with the new reality, saying most of their companies were doomed to failure. To them, no price was too high to pay for their good idea. It was a twisted view born out of the excesses in rising stock prices.
In the end, Buffett was right. But at the time, all he had was an argument built around common sense, facts, and history. Here’s how he relayed it in a speech at the Sun Valley Conference in July 1999:
Let me summarize what I’ve been saying about the stock market: I think it’s very hard t ocome up with a persuasive case that equities will over the next 17 years perform anything like — anything like — they’ve performed in the past 17 years. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate — repeat, aggregate — would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that’s 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.
Let me come back to what I said earlier: that there are three things that might allow investors to realize significant profits in the market going forward. The first was that interest rates might fall, and the second was that corporate profits as a percent of GDP might rise dramatically. I get to the third point now: Perhaps you are an optimist who believes that though investors as a whole may slog along, you yourself will be a winner. That thought might be particularly seductive in these early days of the information revolution (which I wholeheartedly believe in). Just pick the obvious winners, your broker will tell you, and ride the wave.
Well, I thought it would be instructive to go back and look at a couple of industries that transformed this country much earlier in this century: automobiles and aviation. Take automobiles first: I have here one page, out of 70 in total, of car and truck manufacturers that have operated in this country. At one time, there was a Berkshire car and an Omaha car. Naturally I noticed those. But there was also a telephone book of others.
All told, there appear to have been at least 2,000 car makes, in an industry that had an incredible impact on people’s lives. If you had foreseen in the early days of cars how this industry would develop, you would have said, “Here is the road to riches.” So what did we progress to by the 1990s? After corporate carnage that never let up, we came down to three U.S. car companies — themselves no lollapaloozas for investors. So here is an industry that had an enormous impact on America — and also an enormous impact, though not the anticipated one, on investors.
Sometimes, incidentally, it’s much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money. But there was one obvious decision you could have made back then — it’s better sometimes to turn these things upside down — and that was to short horses. Frankly, I’m disappointed that the Buffett family was not short horses through this entire period. And we really had no excuse: Living in Nebraska, we would have found it super-easy to borrow horses and avoid a “short squeeze.”
Now the other great invention of the first half of the century was the airplane. In this period from 1919 to 1939, there were about two hundred companies. Imagine if you could have seen the future of the airline industry back there at Kitty Hawk. You would have seen a world undreamed of. But assume you had the insight, and you saw all of these people wishing to fly and to visit their relatives or run away from their relatives or whatever you do in an airplane, and you decided this was the place to be.
As of a couple of years ago, there had been zero money made from the aggregate of all stock investments in the airline industry in history. So I submit to you: I really like to think that if I had been down there at Kitty Hawk, I would have been farsighted enough and public-spirited enough to have shot Orville down. I owed it to future capitalists.
It’s wonderful to promote new industries, because they are very promotable. It’s very hard to promote investment in a mundane product. It’s much easier to promote an esoteric product, even particularly one with losses, because there’s no quantitative guideline. But people will keep coming back to invest, you know. It reminds me a little of that story of the oil prospector who died and went to heaven. And St. Peter said, ‘Well, I checked you out, and you meet all of the qualifications. But there’s one problem.’ He said, ‘We have some tough zoning laws up here, and we keep all of the oil prospectors over in that pen. And as you can see, it is absolutely chock-full. There is no room for you.’
And the prospector said, ‘Do you mind if I just say four words?’
St. Peter said, ‘No harm in that.’
So the prospector cupped his hands and yells out, ‘Oil discovered in hell!’
And of course, the lock comes off the cage and all of the oil prospectors start heading right straight down.
St. Peter said, ‘That’s a pretty slick trick. So,’ he says, ‘go on in, make yourself at home. All the room in the world.’
The prospector paused for a minute, then said, ‘No, I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.’
Well, that’s the way people feel with stocks. It’s very easy to believe that there’s some truth to that rumor after all.
I won’t dwell on other glamorous businesses that dramatically changed our lives but concurrently failed to deliver rewards to U.S. investors: the manufacture of radios and televisions, for example. But I will draw a lesson from these businesses: The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
A couple of lessons come out of this.
First, as Buffett shows, picking the winners of major innovations is difficult. Most winners are only obvious in hindsight. The same can be said for moats.
A great story can always be weaved around a new innovation, but even the best ideas have limits. And picking winners gets harder as stock prices become overwhelmed by greed.
Second, sometimes betting against the losers in the disrupted industry is the better bet. It’s not always easy, though, because sometimes the disruption takes longer than expected.
Third, when prices reach unsustainable heights, the “winners” survive, but investors are the clear losers. If prices are unsustainable, and reversion is inevitable, it will end badly eventually. The question is always when.
Those who understand the limits, realize the inevitable, and avoid being drawn back into the euphoria, have the best chance to avoid permanent losses in the collapse.