Annual growth rate lesson can be applied to macroeconomics and companies

By DAVID MOON, Moon Capital Management, LLC
June 17, 2012

About five years ago, investment analyst Jeremy Grantham was speaking to a group of quantitative geniuses – mathematics PhDs – about common algebraic logic flaws.

He gave an example showing the lunacy of assuming seemingly modest growth rates into perpetuity. Consider the notion of a 4.5 percent annual growth rate in an economy.

The Ancient Egyptian culture existed for more than three millennia. Imagine that 3,000 years ago, all of the material wealth of their entire society would have fit into a box the size of the bed of a pickup tuck. If the Egyptian economy grew 4.5 percent a year for the next 3,000 years, how much material wealth would that culture have accumulated, beginning with that admittedly understated starting point?

Grantham posed this question to his smart math crowd, challenging them to think big. Some of the professors guessed massive things like “miles around the planet” or “from here to the moon.”

Neither of those is even close. No one in this group of highly-trained mathematicians came within one billionth of one percent of the actual answer.

The volume is so large that it would not fit into a billion of our Solar Systems.

Keep in mind: 4.5 percent is not a number so far-fetched that only wild lunatics would consider that an economy could sustain growth at that rate for any meaningful period. The fiscal year 2013 executive federal budget request projects that by 2015 the US economy will reach its assumed long term sustainable growth rate: 4.1 percent annually, or just a hair behind the ridiculous Pharaoh farce.

Former Chairman of the Council of Economic Advisors, Herbert Stein, once said that if something cannot continue forever, it will eventually stop.

It is a lesson that applies to all of life, including both macroeconomic growth rates and individual company performance.

In January 2000, Wal-Mart stock was trading at a Pollyannaish price relative to its earnings. The price could only be justified if the company continued its growth rate of the previous 25 years for the next quarter century.

How likely was that?

From 1972 to 1999, Wal-Mart's annual revenues grew from $78 million to $137 billion, or at an annualized rate of a little more than 30 percent. If the company continued to grow at that same rate for the next 25 years, by 2025 Wal-Mart revenues would total almost $100 trillion per year.

The total GDP of the US is only about $15 trillion per year.

Investors who purchased Wal-Mart in January 2000 were very bad at math. Or, more likely, they struggled composing an independent thought and simply bought the stock because everyone else was buying it.

It's not impossible to make 20 or 50 times your original investment on a stock. But it is almost impossible to do so by chasing the fad of the day.

Testing the plausibility of an alluring promise requires only the most basic skills in common sense and algebra – but they don’t work if they aren’t used.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

Click here to subscribe to MCM commentary.

MCM website