What the Law of Diminishing Returns Means for the U.S.

 

There are several applications of the Law of Diminishing Returns, most commonly used in reference to marginal production of labor (which I could not find a good chart of), but in this case we also have an example of optimal power use.

There are also practical applications of this law to the markets, and stocks themselves. Companies are first bought for their growth prospects, and inevitably they mature; see Citi (C), GE (GE), or any company in the Dow Jones Industrial Average.

Citi and GE are examples of companies which have simply grown to be too large (Citi is was a $2.2 trillion company, and GE has a market cap of $283 billion). It's not that they are not competitive in their respective industries, it's only that they have limited upside due to lack of further growth (as you can see in the chart above, 1 share of GE is practically worth the same nominal amount after 5 years). 

For example’s sake, let's say Berkshire Hathaway (BRK.A) acquired a small cap materials company which doubled its returns one year after the acquisition; those profits would be negligible on Berkshire’s balance sheet.

This has been an inconvenience to investors in the United States for a while, as we are maturing as a nation. The addition of billions of dollars to our GDP amounts to a very small amount regarding the total (its been near 1%-2% per year), hence the diminishing returns. No wonder hedge funds/investment banks are levered 25 to 1…25 times 2% turns into a good return, but it comes with consequences when abused, as we have seen.

Finally, the question; what does this mean for the future of the US? we have had some bad recessions including the tech bubble, but this one is being lead by financial instruments which got out of hand, and driven further by bad bets (this is not reminiscent of old fashioned value investing).

Perhaps this is why we have witnessed a shift to stocks which have natural growth prospects, those which have exposure to demand driven markets: Rio Tinto (RTP), Vale (RIO), Southern Copper (PCU), Monsanto (MON), Potash (POT), US Steel, XTO (XTO), Apache (APA), and Petrobras (PBR).

Materials and Energy are emerging as secular themes in global markets, and this may be the beginning of a trend which leaves the US in the dust as a global importer of raw materials…after all, we’re only a nation of 340 million people, whereas China and India make up close to 3 billion combined (or half of the world).

Disclosure: Author holds a long position in RTP

Comments

[svkoho]

good article with one of the most important graphs in the world as well as one of the most important concepts which is increasing complexity and size is beneficial to a point and then adding more "power" or complexity or bureaucracy or whatever results in diminishing marginal returns; important at looking for companies in which to invest or looking at the fate of civilizations as they reach their peak and then go into their death spiral phase.......

[paulk8756]

Sounds alot like our old friend Jimmy Carter. It took us several years to return to growth after his stint in the White House. We can only hope we're as lucky this time around!

[Awakened]

Paul, I think you meant to refer to the Honorable Paul A. Volcker, not Jimmy Carter since Volcker was the chairman of the Federal Reserve System at the time that President Carter was in office. And while there are alot of similarities now to when Carter was in office, there are many differences that now make our current situation unique. These differences are articulated well in a speech Volcker made to the Economic Club of New York on Tuesday, April 8, 2008. He was celebrating his 80th Birthday.
econclubny.org/files/T...
When Carter was in office we had laws regulating the banks including the Glass-Steagall act and the uptick rule.
Volcker makes a special point regarding Hedge funds stating, "Hedge funds when managed carefully may add to the efficiency of markets. However, the potential for trouble has been amply demonstrated particularly when those funds are sponsored by banks...Banks in their lending need to resist the dangerous and excessive leveraging of businesses acquired by equity funds, The potential for conflicts of interest strongly suggests the most careful consideration of the governance structure of the equity and hedge funds including independence from bank sponsorship."
The bankers and others feeling the law of diminishing returns have made some poor and risky choices and are we are all now experiencing the results of those risky choices.
Again according to Volcker, "The transient pleasures of extreme leveraging have been exposed....The need for regulatory reform is broadly recognized."

[Awakened]

If you want the speech you will have to google it