Imagine a prize fight in which the boxer in one corner is a 5-foot-tall, 125-pound featherweight, and the slugger in the opposite corner is a 6-foot-tall, 250-pound heavyweight. Doesn’t quite seem fair, does it? Well, in business, these mismatches occur all the time, although appearances can be deceptive.
Let me first define the circumstances of these bouts, which indeed they are when viewed in terms of the performance of the different asset classes within a portfolio. Regulations, taxes, and inflation direct the behavior of all companies; they affect the economic stage, the ability of firms to turn profits, and, ultimately, the level of stock prices. Simple enough. But in an important sense, these three factors determine the ring conditions under which all businesses must come to blows. And this is where the mismatches come in. Sometimes the ring is slippery and favors the nimble, quicker fighter. Other times the ring is small, favoring the bigger, more powerful punchers.
Think of it. At times we can say that the burden of regulations, taxes, and inflation within a country is high. Taken together, these economic variables set a very dangerous and treacherous stage. Only the lighter and more nimble fighters will be able to negotiate the stage. The nimble fighter will take on all challengers within a country’s borders. Yet not all fighters are built the same. Let’s say that in Country A, Large-Cap A has sales of $100 billion and Small-Cap A has sales of $500 million. Clearly, these are fighters of a different stripe. How will each perform in the domestic economic ring? Just the same? Certainly not.
The fix is in, of course. As a group, businesses in the free market always will be victorious over the combined burden of regulations, taxation, and inflation, the specific set of shocks that concerns us in this chapter. The new equilibrium will be achieved. But the rounds of these fights are worth watching. Sometimes we’ll see a company bob and weave and score points early on, only to run out of steam later in the fight. Other times we’ll see a business get pummeled in the opening rounds, only to land a knock-out blow before the final bell. Fundamentally, when uncertainty emerges within national borders, you want to know which of its opponents deserve your investment dollars and in which rounds. This chapter gives you such expertise.
If a boxer with national appeal had the option of fighting in the high-school gymnasium in Anywhere, U.S.A., or in Madison Square Garden in New York City, which venue do you think he’d choose? One would presume the latter because it would offer a larger audience, a greater dollar volume at the gate, and, hence, a superior purse. So it is with our public companies. Motivated by profit, companies seek the widest audiences—the largest and most visible venues—possible. For a time, the high-school gymnasium will have to do, but the persistent compulsion is toward center ring at the Garden.
Of course, the catchphrase that “size matters” is used with a little naughtiness these days, but in business and investing, it matters a great deal. Among our pair-wise portfolio choices is large-cap versus small-cap, a simple delineation based on size. Small-caps, in general, have dollar sales in the hundreds of millions; large-caps in the hundreds of billions. Small-caps and large-caps will perpetually coexist. However, within industry groups, the largest companies will at times enjoy inherent advantages over the smallest simply because they are bigger. Specifically, larger companies will have an advantage when the costs of doing business become “fixed,” or predictable.
Let’s say that it will take a fixed amount of paperwork to introduce a new product into a country, regardless of how many units are likely to be sold. With that paperwork comes a new fixed cost. It follows that the largest companies within sectors will be better suited than their smaller competitors to pay back these costs, a reality that will lead to increased consolidation and fewer (larger) companies eventually dominating each industry.
For a quick case study of this move toward the large and of how fixed costs play unequally on companies in relation to their size, we can look to the megaregulation known as the Clean Air Act.
In 1970, legislators in Washington passed the first full-fledged version of this act, establishing the EPA as its enforcement agency. With cleaner American air and better fuel mileage as the stated goals, the act mandated that carmakers conform to a set of strict emission rules—a full 90 percent reduction in automotive discharge.
One solution was to outfit all new cars with catalytic converters, exhaust-system devices that turn pollutants into more acceptable atmospheric gasses. Largely, as a result of antirust regulations, GM, Ford, and Chrysler—the Big Three automakers at the time—each set out to develop these converters, which, from my point of view, meant that Detroit would develop two catalytic converters too many. The costs for developing these converters were roughly the same for each of the firms, which, in addition to other fixed costs related to the Clean Air Act, had a clear size-related impact. Because greater capacity begets greater efficiency, which begets lower costs, the unit costs would climb the most for the smallest of the Big Three.
At the time, GM was a giant, Ford was relatively large, and Chrysler was a distant third in terms of size. Not surprisingly, Chrysler was put at a competitive disadvantage once the new regulatory rules were established and suffered the most during the period, even when you account for the energy crunch, runaway inflation, and heightened foreign-car competition that characterized the 1970s (see Table 13.1). When catalyst-endowed cars first rolled off U.S. assembly lines, some in the industry began talking of the “Big Two,” sans Chrysler.[1]
Table 13.1. Big-Three Automotive Revenues and Net Income 1970–78[*]
Chrysler Revenues | Net Income | Ford Revenues | Net Income | GM Revenues | Net Income | |
|---|---|---|---|---|---|---|
1978 | 13,618 | –205 | 42,784 | 1,589 | 63,221 | 3,508 |
1976 | 15,537 | 423 | 28,840 | 983 | 47,181 | 2,903 |
1974 | 10,860 | –52 | 23,621 | 361 | 31,550 | 950 |
1972 | 9,641 | 221 | 20,194 | 870 | 30,435 | 2,163 |
1970 | 7,000 | –8 | 14,980 | 516 | 18,752 | 609 |
[*] U.S. dollars in millions | ||||||
As the smallest of the domestic Big Three, Chrysler sucked it up for much of the 1970s. But it persisted in the decades that followed, nibbling away at the market share of its U.S. competitors. Eventfully, it merged with Germany’s Daimler-Benz in 1998 to create a truly global concern, and though DaimlerChrysler stumbled a bit out of the gate, Chrysler’s move to the large—and toward the minimization of the impact of fixed costs—has been near textbook.[2]
A few monster prize fighters competing in one intraplanetary ring in pursuit of a mega payday? Is this the future?
To a degree. Globalization is a compelling argument for the largest of the large-caps capturing an outsized chunk of the profits within their industries in the decades and centuries to come. But I am not, by any stretch, suggesting that you put all your money in this one super-basket and call it a day.
Just as certainty in business and investing will never be 100 percent, a true single market will never completely materialize. Pockets of differentiation always will exist. Smaller venues, offering smaller purses, will attract the lighter-weight prize fighters: the small-caps. There forever will be a California or France that regulates itself toward disadvantage on both a regional and global basis. There perpetually will be a Hawaii or South Pacific that, based on the natural endowments of sand, palm, and sunshine, will draw specific tourist dollars that other locations cannot claim. There always will be a Dominican Republic, my small pond of birth, where some small-cap businesses will flourish below the large-cap radar. (In my D.R., organic farmers have done just that.)[3] There perpetually will be a Country A that lowers taxes and a Country B that raises them—and the flight of capital toward Country A that ensues.
Consequently, we can talk of two “venues,” national and global.
The global venue is the future single world market—a work in progress, eternally perhaps, but nonetheless an increasingly prevailing force. This grand stage is for the super large-caps, those companies with facilities all over the world and the ability to shift production toward the most advantageous economic environments. Because these companies are so big and can mechanically shift operations in the direction of advantage, they are the most shock-resilient.
Then there’s the national venue, across which the winds of uncertainty often travel. This can be described as any global location where tax, monetary, regulatory, and trade policies differ from other locales. Earlier we discussed the location effect in terms of the economic shocks that bring about pockets of market differentiation. The lesson still applies: Erase the borders on your globe as they are currently drawn and retrace them based on the levels of transaction costs that exist between regions when economic shocks occur. That said, there are, in fact, times when the transaction-cost borders as they are currently drawn will serve you just fine.
We already know that the relative size of companies will relate directly to their performance when economic shocks occur. In California, when regulatory controls on energy led to the lights going out, small-caps performed much worse than large-caps because the former, many of which have single plant facilities, were stuck in the state and the latter could shift production outside the shock zone. In this example, size became our proxy, or stand-in, for companies that had the ability or inability to shift production outside of a region. In other words, company size allowed us to determine the level of locational, or physical, elasticity. And we derived an important rule from this: When negative shocks impact specific locations, locationally inelastic small-caps likely will underperform locationally elastic large-caps.
But when focusing on elasticity with respect to the combined burden of regulation, taxation, and inflation, size becomes a proxy for the ability of companies to adjust to the changing economic environment.[4] This turns our earlier locational rule on its head:
When shocks—in particular, those related to regulations, inflation, and taxes—affect national economies, large-caps likely will underperform small-caps.
To see this in the clearest light, we must further separate our fighters by weight class.
Taxes and regulations are typically targeted at the largest companies within national borders; when governments tax and regulate, they like to go after big game.
As for taxes, big is where the greatest potential revenue is, while the populist tendency of governments is to tax the larger, “richer” companies at a higher level than the smaller companies, which might be stifled under a tax burden that is too lofty. As for regulations, small-cap favoritism also exists: Governments frequently stick provisions into legislation that exempts smaller companies outright or protects them from stricter levels of compliance.
Inflation, meanwhile, causes what economists call “bracket creep.” Simply, it pushes people and businesses into higher tax brackets, essentially increasing their tax rates.
Putting all this together, like lightweight fighters, small-caps will appear nimble and quick when adverse changes to taxes, regulations, and inflation threaten or arrive. Indeed, bobbing and weaving are the fortes of small-caps, which might “hedge” against inflation (putting assets into safe havens), “shelter” themselves against high taxes (through legal but crafty means), or “skirt” regulations (for example, by morphing the way business is done so that certain regulatory rules no longer apply). And how will our large-caps perform at this juncture? Like slow-footed behemoths.
But these are the earlier rounds of the fight. When uncertainty increases, the costs are not fixed. And when they do fix and certainty returns—meaning the tax, regulatory, and inflationary environments become knowable and predictable—the combined regulatory burden becomes something of a stationary target, one that is tailor-made for the corporate power punchers, those big, brawny (and national) large-caps.
If I were to show a chart of the relative performance of small- and large-cap stocks over the last 31 years to professionals in the investment community, I would more often than not receive a shrug. Since the dawn of asset allocation, which wasn’t all that long ago, small- and large-cap stocks have exhibited periodic behavior, whereby one beats out the other for a few years before switching.
Well, in Figure 13.1, I have provided such a chart, and from where I sit, a shrug is hardly the right reaction.
The table shows the annual returns of U.S. large-caps (shaded boxes) and small-caps (white boxes) between 1975 and 2005.[5] If we overlook the one-year size shift that occurred in 1988, considering it to be an anomaly for now, five distinct size cycles come into view. From my perspective, random periodic behavior this is not.
Reflecting on this chart, an investment analyst who adheres to the sentiment that small-caps are the best bet for investors over the long run would say my data is a further endorsement of investing fact. And he’d have a point. Indeed, small-caps beat out large caps in 21 of the 31 sample years—more than two-thirds of the time.
However, I’d ask, “Would you always bet on a fighter who wins two-thirds of the time?”
“Yes,” he’d respond. “In the long run, I’ll make money if I place equal bets on all of his fights.”
“But what if you had a strong sense of when this fighter would lose that one-third of the time? Would you still bet on this fighter to win all of the time?”
“No, I wouldn’t,” he’d respond, catching my drift. “But it’s difficult to know such things. That’s why I ‘bet’ the long-run trends. It’s the safest way to go, and not a bad business.”
At this point, I would smile and nod, perhaps shrug, and walk away. There always will be those investors who, in the safe pursuit of profit over the long run, resign themselves to losing one-third of the time—or even more. But cyclical investors are motivated to capture the fractional historical differences that the purer long-run investors toss aside.
Indeed, if you know your recent U.S. economic history, Figure 13.1 becomes a scorecard on which to base decisive future action. For each period in the sample, when small-caps beat large-caps, the economic environment can be described as one in which inflation, taxation, and regulation were in flux—an uncertain environment. And when large-caps beat small-caps, inflation, taxes, and regulations were steady, for the most part—a proven recipe for certainty.
In what follows, I describe each of these cyclical periods in detail, an exercise that will help you describe both certain and uncertain economic environments in the future. But first I restate a warning: I have my political views and you have yours, and they might be as diametrically opposed as night and day. But who really cares? As investors, we should stand in cold allegiance, basing our actions not on political emotion, but on the hard facts. If Political Action A causes Economic Result B nearly all the time, we possess reliable information and, hence, a pretty good basis for investment action.
So on with the national fight.
The venue is the United States of America. The years are 1975 to 2005, a period in which the uncertainty monster climbs in and out of the economic ring. Our corporate fighters—our nimble and lightweight small-caps, our brawny and heavyweight large-caps—are gloved and ready for battle.
Place your bets.
The period 1975–83 can be divided into two phases: an initial seven years of profound uncertainty and a two-year transitional period when businesses and the economy weaned themselves off the doubt and dismay that characterized most of the previous decade.
Inflation infamously swelled during the 1970s, while tax policy in this environment was hesitant and temporary—two moods that only nourish the uncertainty beast.[6] And then there were the regulations. Regulations in America historically have come in waves, and a great regulatory tidal wave hit in the 1970s in response to the environmental and safety movements of that era.[7] With each new act and agency (there were dozens) a stack of new rules and restrictions landed on the corporate desk—not to mention reams of added paperwork and legal fees. Of course, it would not have been the 1970s without energy-price controls of nearly every size and stripe.
But the scene shifted dramatically with the turn of the decade. In 1981, the fledgling Reagan administration passed a landmark tax-cut package, the centerpiece being a steep cut in individual tax rates. The cuts were phased in, helping prolong uncertainty until they were fully implemented in 1984, although uncertainty was clearly on the way out. For instance, even though small-caps outperformed large-caps in 1982 and 1983, large-caps did not perform poorly during these years.
Additionally, by 1984, it was evident that the Fed had gotten inflation right: In January of that year, inflation was down to about 4 percent from nearly 12 percent at the start of 1981. The Reagan administration also had been diligently trimming back the regulatory burden. Initially, it required agencies to outline new regulations in terms of “net benefits,” the difference between the social benefit and social cost.[8] It also significantly reduced the annual flow of major new regulations (from triple to double digits) while lifting price controls on oil and gas.[9]
With taxes lowering, inflation (at long last) settling, and the regulatory burden lessening, certainty—and a sustainable large-cap cycle—finally emerged.
The period 1984–90 is storied for its economic certainty. In these “seven fat years,” as former Wall Street Journal editor Robert Bartley termed them, inflation held relatively steady between 3 and 5 percent (dipping near 1 percent in late 1986), a momentous turnaround from the previous decade.[10]
In 1986, individual tax rates were slashed again (the top rate falling to 28 percent), corporate income taxes were lowered (the top rate dropped to 34 percent), and personal exemptions were increased. During the seven fat years, businesses enjoyed the certainty that fiscal policy, for the most part, would be favorable and monetary policy stable. The regulatory story, by and large, also was consistent: The Reagan administration continued to slow the flow of red tape and strike hundreds of restrictions from the books.
A complete-certainty world? No. Every cycle has its bumps, and sometimes these bumps foretell a cycle’s end.
One of the bigger bumps of the Reagan years was the savings and loan (S&L) crisis. This is an involved story featuring shady political deals, questionable regulatory oversight at the agency level, and outright crooks. Jumping to the outcome, it culminated in the elimination of more than a thousand S&Ls (roughly a third, by way of bankruptcies and mergers) and a bailout by the federal government in the hundreds of billions of dollars.[11] It also led to much stricter regulations for all banks. In 1989, the American Banking Association said regulation already had reached a “crisis stage” and that the pro-regulation fever of policymakers in the wake of the S&L disaster was only making matters worse.[12]
In the last of the fat years, the transition back to greater uncertainty also included the start of a recession and the denouement of one of the greatest political blunders in modern presidential history. After gaining office on the pledge of “Read my lips: no new taxes,” President George H. W. Bush signed a bill in the Rose Garden that hiked taxes on tobacco, gas, alcohol, and other items.
Inflation pushed over 6 percent in 1990 but was pulled back to the 3 percent range in 1991, the year in which a brief eight-month recession also ended.[13] But the damaging interaction of higher inflation, taxes, and regulations stuck around a little longer.
As vice president under Reagan, Bush Sr. headed that administration’s regulation-reduction task force. But in his one term in the Oval Office, Bush helped fatten the regulatory burden, the primary thickeners including the Clean Air Act (1990; an expansion), the Americans with Disabilities Act (1990), the Federal Deposit Insurance Corporation Improvement Act (1991; a sweeping S&L crisis reform), and the Nutrition Labeling and Education Act (1992).
Then in 1993, the freshman Clinton team raised fuel, individual, corporate, and Social Security taxes. Correspondingly, the Clinton agenda featured sweeping health care reform, an idea that grew into a 1,342-page regulatory bill that, if passed, would have nationalized the country’s health system.
But the 1991–94 cycle is notable for its lightness and shortness: Small-caps were the winners for the four-year period, but large-caps didn’t perform too shabbily overall. Though new layers of uncertainty had blanketed the economy, apparently they were not too thick.
A prevailing fear among businesses in 1993 and 1994 was that the Clinton health care plan would become reality. The program portended an enormous government expansion—one that would have to be funded somehow (i.e., tax increases)—as well as a potentially huge increase in the regulatory burden. Forty percent of corporate executives polled in a 1994 Fortune survey revealed they had reduced their employment plans based on fears of these higher costs.[14]
Apparently, similar fears gripped members of Congress, and in 1994, the Clinton health care plan was firmly defeated. Then in the midterm elections that year, Congress flipped majority parties from Democrat to Republican, an electoral nod to restraint over bigger government. This GOP “takeover” was termed a revolution by the victors, who carried to Congress a platform of tax-rate reductions, spending cuts, and deregulation. This put the executive and legislative branches in opposition, stances they would retain for most of the next six years.
In 1995, as the new Congress settled in, the president pulled out his veto pen, something he would do many times in what have come to be known as the gridlock years. And businesses didn’t mind at all. Newsweek’s Wall Street editor wrote in 1998 that “for savvy U.S. business people, political gridlock is almost as much fun as making money. If Clinton (or Gore) and Congress spend all their time fighting each other ... they’re more likely to leave the rest of us alone.”[15]
An additional factor supporting certainty was that the only alternative to gridlock was consensus; the president and Congress would have to meet in the middle if they were to meet at all. And for businesses, the middle wasn’t so bad. In the vein of compromise, the president signed a tax bill in 1997 that included a reduction in the top capital gains rate from 28 to 20 percent.
Deeds and words both add to certainty (or uncertainty). In late 1996, while the economy was enjoying another year of expansion and stock markets were humming along, then–Federal Reserve chair Alan Greenspan entered two words into the national lexicon that forever will be equated with uncertainty: “irrational exuberance.”[16]
Greenspan had managed monetary policy with a deft touch to this point and also did so for the near term that followed. But that phrase hung heavy in the air, and for good reason: It pointed to the fear that the Federal Reserve might very well put the brakes on the economy through interest-rate hikes to calm a vibrant bull market—one that, if left unchecked, would collapse of its own weight and bring the economy down with it (or so the theory went). Y2K concerns—the fear that computers would not be able to distinguish 1900 from 2000 at the turn of the century, a “bug” that would shut down businesses globally—were also ripe in the air. The tone of the Federal Reserve increasingly became one of restraint and caution.
And in 1999, the deeds followed. In an attempt to cool off the economy and, hence, the stock markets, Greenspan began to increase the regulatory burden through a series of interest-rate hikes that he continued through May 2000—six hikes in all that lifted the overnight interest rate from 4.75 to 6.5 percent.[17] In March 2001, the economy began what would be an eight-month contraction. The Fed’s cooling effort had a chilling effect.
At the start of 2001, the Fed began a reverse policy of interest-rate cuts in an attempt to re-energize the economy. But on September 11, 2001, at the tail end of the recession, terrorists steered airplanes into the World Trade Center and the Pentagon, and everything, as they say, changed for good.
At this point, the Fed began adding a large amount of liquidity (or cash readiness) to the economy, partly as a response to the shock of 9/11 and partly to cure what had become a deflationary recession. By June 2003, it had reduced the federal funds interest rate to a historically low 1 percent, where it held for a year. Additionally, in 2003, Congress passed and President George W. Bush signed an investment tax cut that immediately lowered the capital gains and dividend tax rates each to 15 percent. The economy surged almost instantly and climbed in a sustained way in the coming years. But the small-cap cycle persisted, for a number of reasons.
Geopolitical uncertainty locked itself in place on 9/11. Suddenly, the U.S. was at war, war being yet another synonym for uncertainty. Then there’s regulation. In 2002, after a string of corporate accounting scandals rattled investor confidence, Congress passed the Sarbanes-Oxley Act. This enormous regulation, an attempt to elevate the quality and transparency of financial reporting, greatly increased paperwork, SEC compliance costs, and legal fees for American businesses, costs that would not “fix” right away because certain provisions of the act were rolled out. Compliance “established” itself as an ongoing, developing, and sometimes head-scratching matter. Bizarrely, but not surprisingly, this legislation earned its very own “for dummies” book, Sarbanes-Oxley for Dummies.[18]
Uncertainty—the interaction among taxes, inflation, regulations, and sometimes more—has a way of piling up.
A dollar invested in our basket of large-cap stocks in January 1975 would have grown to $50.04 by the end of 2005. That is a 13.45 percent compounded annual rate of return and, historically, not a bad return at all. (For comparison’s sake, Jeremy Siegel, in his Stocks for the Long Run, shows that large-caps returned about 11 percent between 1926 and 2000 on a compounded annual basis.)[19] Meanwhile, a dollar invested in small-caps in 1975 would have grown to $198.54, a phenomenal gain that translates to an 18.61 percent annual return. If you invested your entire nest egg in small-caps during this period, you would have generated returns that exceeded the large-cap benchmark by 5.16 percentage points annually. As a pure long-run strategy, you would have to be considered among the smart investors if you held to a small-cap program for the full 31-year period.
However...
If you employed a cyclical switching strategy between 1975 and 2005, whereby you acted on the size performance of asset classes in relation to the prevailing levels of economic certainty and uncertainty, you would have proven much smarter.
One dollar invested in small-caps in January 1975 and appropriately switched thereafter based on the small- and large-cap cycles through December 2005 would have grown to a whopping $424.46. This strategy would have produced a breakneck 22.38 percent compounded annual rate of return, outperforming the all-small-cap strategy by 3.77 percentage points per year and the all-large-cap strategy by 8.93 percentage points annually.
As a result of the interaction among inflation, taxes, and regulation, economies switch between uncertainty and certainty without asking your permission. But as an investor, you have every opportunity to switch between the appropriate “fighters” during each of these environments. It’s really only a question of whether you want to win some of the time or most of the time.
How about winning all the time? Well, one must be realistic. Capturing the full breadth of every size cycle within national borders is difficult because the effects of tax rates, regulations, and inflation on asset values don’t always respond on cue. Responding “near cue,” though, is another story. During each of the five size cycles discussed in this chapter, once the environment emerged, it stuck around for a good while—for several years and more.
The job, then, is to track changes to inflation, tax rates, and regulation as they develop and to act once they establish.
Let’s say it is 1982 all over again and your U.S. indicators are beginning to blink “certainty.” Taxes have been lowered. The regulatory flow has been lessened. And inflation is trending down. Still, small-caps are outperforming large-caps. Same for 1983, although you notice that both small-caps (+39.7 percent for the year) and large-caps (+22.5 percent) are doing well. Then it’s 1984, and large-caps finally beat out small-caps (with small-cap returns actually turning negative). Well, it might be early 1985 by now, but because you took these actions, you made the appropriate switch to large-caps in the U.S. portion of your portfolio:
You watched economic certainty—produced by lower tax rates, regulations, and inflation—gather and then establish.
You understood that tax, regulatory, and inflation cycles tend to last several years or more.
You knew that large-caps tend to be inelastic with respect to changes in tax rates, the inflation rate, and the regulatory burden, and thus will outperform small-caps when these variables are low or declining.
You recognized that small-caps are elastic with respect to taxes, inflation, and regulation, and thus will outperform large-caps when these variables are high or increasing.
Despite a one-year blip in 1988, when small-caps beat out large-caps (although both did well), you would have been correctly allocated for most of the next six years.
But what if you caught only five years of this cycle? Or four or three? In truth, the differential in performance between large- and small-caps is great enough to suggest that capturing even a fraction of these cycles will enhance your portfolio returns in a significant way.
When you think of it, you have a certain competitive advantage over the stocks you invest in. One year you can be large-cap, and the next year small. No company can do that, and you need only develop the confidence to act on this advantage. Here, your ability to spot distinct economic environments and your understanding of how asset classes behave in these environments are inseparable: The more you know about the cyclical nature of asset classes, the more certain will be your investment actions and the better will be your performance.
Of this, I am certain.
| 1. | Allan J. Mayer and James C. Jones, “Chrysler’s Shake-Out,” Newsweek, 14 July 1975, 61. |
| 2. | Describing the natural move “to the large” in terms of the auto industry has its difficulties. At the start of the new century, Ford and GM were still giants in their field, although they probably received more press about their predicted bankruptcies than anything else. Over the years, Detroit has always struggled to meet one cost variable: its unions. Worker pay, health benefits, and retirement benefits have all been bid up in the union negotiation process, to the detriment of the cost-effectiveness of Detroit. Product matters, too, and Detroit’s output has not always matched up with the burgeoning foreign competition. One can look at Toyota: Once an innovative, fleet-of-foot start-up, it is now a “Big Four” member, along with DaimlerChrysler, Ford, and GM. But there it is again, that move to the large. Union woes, poor management, bad breaks, and ill-conceived products aside, the moral of the story still holds: It is in the DNA of public companies to grow. |
| 3. | When the doors to free trade opened in the Dominican Republic, farmers there were in a bit of a pickle. How could they compete with the U.S. agricultural business? What would they grow? It turns out that the answer was right in front of them. In the coveted U.S. produce market, organically grown fruits and vegetables were (and still are) in high demand, an offshoot of a cultural movement toward health and wholesomeness. But D.R. farmers had been growing organically for years mostly because chemical fertilizers are so expensive. So right from the start, they had a competitive advantage: When it came to growing organically, they knew what they were doing, and soon enough these small-cap farmers were competing for retail space in the U.S. and Europe. |
| 4. | The investing strategy for the mega large-caps, or what we might call the super heavyweights, must be separated from any strategy concerned with investing specifically within national borders. Because these big hitters are not bound by the rules of any one country, investing in them should become a matter of estimating which industries will perform the best in relation to the global economic environment. |
| 5. | In computing the results reported in Figure 13.1, I used the S&P 500 as the proxy for domestic large-cap stocks, and the Russell 2000 and S&P 600 as the proxies for domestic small-cap stocks. |
| 6. | Inflation data in this section is based on the consumer price index as compiled by the Bureau of Labor Statistics. Historical federal tax-policy data is available from a range of sources, including the U.S. Treasury Department. |
| 7. | Information on major U.S. regulatory programs is made available by the Office of Management and Budget (OMB). Following is a list of several of regulatory acts and agencies to emerge during the 1970s: the National Highway Traffic Safety Administration (1970), the Clean Air Act (1970), the Environmental Protection Agency (1970), the Occupational Safety and Health Administration (1970), the Clean Water Act (1972), the Consumer Product Safety Commission (1972), the Noise Pollution and Abatement Act (1972), the Safe Drinking Water Act (1974), the Materials Transportation Board (1975), the Toxic Substances Control Act (1976), the Resource Conservation and Recovery Act (1976), the Community Reinvestment Act (1977), and the Office of Surface Mining Reclamation and Enforcement (1977). |
| 8. | “Report to Congress on the Costs and Benefits of Federal Regulations,” OMB, 30 September 1997. |
| 9. | Philip Shabecoff, “Reagan Order on Cost-Benefit Analysis Stirs Economic and Political Debate,” New York Times, 7 November 1981. |
| 10. | Robert L. Bartley, The Seven Fat Years (New York: Free Press, 1992). |
| 11. | “An Examination of the Banking Crises of the 1980s and Early 1990s,” Federal Deposit Insurance Corporation (December 1997). |
| 12. | “ABA Report Attacks Red Tape,” International Banking Report, Informa Plc., 1 November 1989. |
| 13. | Business-cycle expansions and contractions are monitored by the National Bureau of Economic Research. |
| 14. | “Fortune Forecast,” Fortune, 6 September 1993, 17. |
| 15. | Allan Sloan, “The Real Bottom Line,” Newsweek, 28 December 1998, 56. |
| 16. | Alan Greenspan, “The Challenge of Central Banking in a Democratic Society,” remarks at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research, Washington, D.C., 5 December 1996. |
| 17. | Historical data on the intended federal funds rate is maintained by the Federal Reserve Board. |
| 18. | Jill Gilbert Welytok, Sarbanes-Oxley for Dummies (Indianapolis: Wiley, February 2006). |
| 19. | Jeremy J. Siegel, “Long-Term Returns of NYSE/AMEX/Nasdaq Stocks Ranked by Size, 1926–2000,” Stocks for the Long Run (New York: McGraw-Hill, 2002). |