Capitalism Hates the Exceptional

Written By Briton Ryle

Posted January 16, 2017

It is extremely difficult for a company to be exceptional for long. If a company is churning out fat profit margins on a great product or service, don’t worry, it won’t last. Some other company will copy your idea. It will sell a product or service that is basically the same thing for less money. And those fat profit margins will be gone — poof. 

Take a simple example like Chipotle (NYSE: CMG). For a decade, it was an exceptional company. It served quality food at a reasonable price to an increasingly health-conscious population. Chipotle just nailed the fast-food diners’ mood: mostly healthy food that’s served quickly. In fact, a whole new style of restaurant was born: fast casual.

Restaurant profit margins are notoriously thin. Half your money goes to labor, another 25% to food costs, throw in rent/mortgage, utilities, insurance, and what not, and you’re probably keeping just a few pennies on every dollar you take in. That was Chipotle in the early days. From 2005 to 2009, net profit margin stayed in the 3–6% range, with a few quarters topping 7%. 

But in the second quarter of 2009, margins jumped to 9%. A year later, Chipotle posted a quarterly margin of 10%. In 2012, it hit almost 12% for a quarter. In 2013, margins were above 10% in three quarters. Starting in the second half of 2014, 10.5% was the low mark. There were five straight quarters with +11% margins. Truly exceptional performance. 

Then a few cases of food poisoning, and it was all over. It’s a pretty safe bet that Chipotle will never see exceptional profit margins again. And it’s not just because of the food poisoning cases — revenue growth was down across the board for the fast-casual space as more chains emerged. 

Whole Foods (NASDAQ: WFM) is another good example. There was a time when it had a corner on the organic food biz. And it had margins basically double those of any other grocer. Then Wal-Mart and Kroger started in with organic food, and Whole Foods has lost its edge. It’s managed to hold onto its margins, but revenue is stagnant. 

Nokia was the biggest cell phone company in the world when the iPhone was released in 2007. Nokia’s share price went from $40 to $9 in pretty much a straight line.

Or look at what Amazon.com is doing to retail across the board. Overall retail sales are up. But they are falling at Macy’s, Kohl’s, and pretty much every other bricks-and-mortar retailer. 

This is capitalism at work. It is both a beautiful and a terrible thing.

You Can’t Stand Still

It’s beautiful because capitalism ensures that there is always opportunity for anyone with an innovative, entrepreneurial spirit. It is purely democratic and a great equalizer: no one is prohibited from participating. If you have a good idea and the drive to action on your idea, I guarantee you can find the backing and the money to give it a go. 

The “next big thing” can come from anywhere…

Jack Ma was a high school teacher before he founded Alibaba. Steve Jobs and Steve Wozniak built kit computers in Jobs’ garage. Facebook was “invented” in a college dorm room. Five Guys started as a burger joint in an Alexandria strip mall. Starbucks grew from one Seattle store.

Speaking of Starbucks, it’s managed to stay exceptional for quite a while now. The company basically invented the whole coffee shop thing, which means the brand is synonymous with coffee, as ubiquitous as “band-aids” or “google.” And Starbucks nails the trifecta: for shareholders, it continues to post excellent margins. For customers, it continues to serve up a quality product. And it has terrific benefits for employees.

That’s why Starbucks was the very first stock I recommended to Wealth Advisory subscribers when I took over in late 2012. We bought the stock at a split-adjusted $22.85. It’s currently over $57, we’ve got 186% gains, and I still consider the stock a must-own. 

Now, I’m sure there will come a time when competition changes the dynamic for Starbucks. But at the same time, Starbucks has already fended off many challengers. Caribou Coffee comes to mind. And remember when Dunkin Donuts was gonna knock Starbucks off its perch? 

So, how did Starbucks keep its edge? It continues to innovate and focus on quality. Starbucks rewards programs are pretty much the best there is. Its gift cards are right up there with Amazon and iTunes. Starbucks doesn’t stand still. It doesn’t rest on its laurels. Because the terrible thing about capitalism is that if you are standing still, you are losing ground. 

Look at U.S. manufacturing. Most people think U.S. manufacturing is a disaster, that all the jobs have gone overseas. But that’s just not true. As I’ve written before, manufacturing is the biggest sector of the U.S. economy — about 36% of GDP in 2015. U.S. manufacturing output has doubled since 1984…

manufacturing output

It’s very nearly recovered to pre-financial crisis levels. But since 2000, the number of manufacturing jobs has fallen from 17.3 million to 12.3 million. That’s 5 million jobs gone, even as more stuff gets made.

The simple fact is that manufacturing has gotten more efficient, more automated. And workers that thought they’d be able to rely on factory jobs have been steamrolled. 

Capitalism and Wall Street 

Right now, the forces of capitalism are doing a number on Wall Street. It’s amazing to watch. I’ve been ranting for years about how hedge funds and mutual funds are huge rip-offs because of their ridiculous fee structures.

If you pay attention to the fees in your 401(k) plan, you know exactly what I mean. Many funds available to 401(k) holders charge annual fees, then entry fees when you buy the fund, and they may charge you exit fees if you sell before a set period (usually at least a year).

Hedge funds are even more ridiculous, with fund managers taking a 20% or higher cut of all profits, in addition to annual management fees. 

But index funds — with fees as lows as -.12% a year — are finally getting their due. In the last two years, over $500 million has been moved into Vanguard funds. In total, around $1 trillion moved from active management funds (where a manager gets big bucks to pick stocks) to passive funds (where the fund simply mimics an index).

Bloomberg says that passive index funds are 70% cheaper than active management funds. That means Wall Street income from fees is falling by 70%! That money is staying with you, the investor. And that is absolutely fantastic. The average investor has been taken for a ride for way too long…

You might think I would be nervous about this. But I actually think it will be great for the newsletter biz. Yes, I fully support investors using index funds to save for retirement. I do it too. But you should also have a Roth IRA account where you own individual stocks for long-term gains.

Roth IRA withdrawals are tax-free when you hit the withdrawal age. No capital gains taxes, no income taxes. That’s 15–25% savings right there.

And my Wealth Advisory newsletter, which costs $49 a year, is a very low-cost way to get excellent research on individual stocks. It’s a perfect complement for the individual investor who has his or her own Roth IRA. 

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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