The list of warning signals for shareholders includes diversification into new industries, changes of business model, massive hiring programs, unfettered CEO power, distracted management, and high capital spending. But top of the list for many is the construction of a new headquarters. Hubris, meet Amazon.com.
Amazon has achieved extraordinary feats, most notably in speed of expansion. It hired more than 30,000 people in the last quarter alone, and in the past three years has tripled its head count to 382,400. It appears to have managed this without a hitch, even as it spent billions of dollars on Hollywood productions, launched a hit gadget and ramped up its spending on research and development.
Investors are betting that CEO Jeff Bezos will keep his magic touch, and that money plowed into expansion today represents big profits to be made some time in the future.
History and human nature are against Mr. Bezos -- and may eventually prove a headwind for much of the rest of the market too.
The lesson from the long term is that companies with high capital spending tend to underperform. Kenneth French, a professor at the Tuck School of Business at Dartmouth College, calculates that shares in the 30% of U.S. companies with the lowest investment returned six times as much as those with the highest investment since 1963.
Human nature provides a story to back up the findings. CEOs like to expand (not coincidentally, CEOs of bigger companies earn more), like to chase new ideas (putting them on the front of popular magazines) and like to do what shareholders want (boosting the value of their stock options, at least in the short run). The three come together when a company or sector is in vogue, as shareholders give it cheap capital and cheer on plans for growth.
Often it turns out that the premise for the expansion was mistaken, and much capital spending is wasted. Remember peak oil, the race to dig new mines to satisfy forecasts of endless emerging-market growth, or the vast overinvestment in shipping to prepare for global trade's inevitable expansion? Those early in the expansion are right to invest, but as more capital is deployed it can drive down prices and destroy the very opportunity shareholders hoped to exploit.
Other times CEOs just fritter the money away, as in the dot-com bubble. If you exercise little control over management and actively encourage them to spend money as quickly as possible, you shouldn't be surprised if much of it is wasted.
The rise and rise of Amazon has come as the patterns of the past seem to have been suspended. Since the start of 2009 the runaway success of big tech stocks and big dividend payers have helped companies with the most and least investment do well, while middling companies underperformed. Calculations by Goldman Sachs' chief U.S. equity strategist David Kostin suggest shareholders have shifted again in the past 18 months, rewarding capital spending with bigger share-price gains than for dividends and share buybacks. If it continues, CEOs will get the message and corporate investment will pick up.
Amazon shareholders might argue that the company won't fall victim to misplaced capital spending because it is exploiting disruptive technology, investing in growth and spending heavily on R&D.
If the past is any indication, these offer up only a glimmer of a hope. History offers plenty of examples of disruptive technologies leading to investment booms, but those caught up in the spending spree usually lose out horribly. The British "railway mania" of the 1840s is a classic example: money poured in from excited shareholders, railroad companies found ways to spend it and were rewarded with ever-higher share prices, until investors discovered just how much of the capital had been wasted. The winners were the broader economy and those who entered early or sold out in time. But much capital had to be written down as profits were competed away or overestimated.
Investing in growth is more plausible. Academics have shown that higher R&D spending on average is followed by better stock performance than for companies with lower R&D spending.