Beware the Productivity Bubble
Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
A big success story coming out of the recession has been the stock market recovery. Though prices have been volatile, overall the S&P 500 is up 80% since early 2009. Despite these gains, stocks still don't appear overvalued. Fears of another stock bubble have been calmed by the observation that the S&P 500's current aggregate price to earnings ratio is a hair under 15, its historical average since 1860. Since we usually regard bubbles as being issues of valuation, where investors irrationally pay more for future earnings, the fact that the earnings are being reasonably valued seems reassuring. But what if the earnings themselves are in a bubble?
Unfortunately, evidence indicates that they are. During the recession, companies were able to expand margins by cutting costs. Many firms laid off large swathes of their workforce while keeping output stable or even growing. The upside to grinding unemployment and a terrible labor market is that corporations were able to squeeze more work out of fewer employees. To be sure, some of this is due to technological advances and sustainable shifts in business practices. For example, companies have been able to cut legal expenses by outsourcing grunt work to India and employing software that is better than first year associates at document discovery, at a fraction of the cost.
More commonly, however, employees are just overworked and underpaid. Corporate pre-tax profits have increased 93% since the first quarter of 2008, but this has gone to enrich shareholders instead of workers, with average wages rising only 0.4% over the same period. Meanwhile, employees feel pressure to work extra unpaid hours and hesitate to take vacation days. In 2011, 57% of Americans didn't use allotted vacation days, sacrificing an average of 11 days. The most common complaints were that taking a vacation would simply require them to work even harder upon their return, and 9% of workers surveyed admitted they were afraid they would get fired if they took vacation. This can't continue, and it won't.
In a worst case scenario, even if high unemployment remains, worker productivity will stagnate or fall as higher stress levels bite into employees' physical and psychological ability to push themselves any harder. The American worker is already the most productive in the world, and there are, after all, only 168 hours in a week. More optimistically, employment will recover at a good pace and firms will be forced to offer more compensation and time off in order to retain talent. Over the past four years, labor costs have been compressed to grow margins, and at some point that tightly coiled spring will unwind. Companies that seem cheap on their earnings today will realize that they can't maintain those earnings, even as they grow revenue. Thus will the productivity bubble burst.
So what's to be done? Prepare your portfolio accordingly. Identify companies that supported earnings primarily through keeping up output while laying off workers, and get rid of them. They won't be able to continue the practice indefinitely. Particularly susceptible are companies like Bank of America (NYSE: BAC) that rely on large numbers of semi-skilled employees. These are the workers that are most squeezed right now, and their bargaining power will expand in an employment recovery.
On the other hand, some firms stand to profit from increased hiring and worker mobility. Professional networking platform LinkedIn (NYSE: LNKD) should see strong subscriber growth as anxious workers seek better opportunities and HR firms work harder to recruit and retain the best matches for openings. Payroll processor Paychex (NASDAQ: PAYX) should realize higher volumes as workforces grow.
Beyond that, companies will feel less pressure from labor costs if they never participated in the productivity bubble in the first place. Apple (NASDAQ: AAPL), for instance, primarily engages two kinds of workers. Creatives like engineers and designers were always in high demand because of their unique skills, and their compensation has remained competitive. Meanwhile, downstream jobs like manufacturing and customer service can be outsourced, shielding Apple from rising wages in the American economy.
Wholesale retailer Costco (NASDAQ: COST) has won accolades from labor unions and shareholders alike for its unusual dedication to its employees, offering higher wages and more personal time than competitors. Employees consistently rank Costco as one of the best companies to work for, so it's unlikely that Costco will face difficulties in keeping its people happy. Finally, heavier international exposure will also protect a portfolio from the productivity bubble, as it is primarily an American phenomenon.
The contraction of margins as wages go up will ultimately be a boon to the economy. One firm's highly productive worker, after all, is another firm's cash-strapped customer. A return to competitive incomes will boost demand and top-line growth throughout the economy. So while the bursting of the productivity bubble is nothing to fear, it is something that investors should prepare for. Invest in companies capable of avoiding or absorbing rising labor costs, and you'll ride out the productivity bust just fine.
Daniel Ferry owns shares of Apple and Costco. The Motley Fool owns shares of Apple, Bank of America, Costco Wholesale, and LinkedIn. Motley Fool newsletter services recommend Apple, Costco Wholesale, LinkedIn, and Paychex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.
