John Hussman on the unsustainability of high-growth and Apple

John Hussman isn't a stock picker—he's more of a macro guy—but he did comment in his April 30th Weekly Market Comment on how high sales growth declines as market share increases, and commented on Apple (AAPL). Kind of obvious but investors, particularly growth investors, often tend to ignore this, often to their peril. [as usual, bold highlights by me]

Consider a very large, untapped market for some product. We can model the growth process in terms of how quickly that product is adopted by new users, whether there are any "network" effects where new buyers are attracted to the product because other people already use it, how frequently existing users replace their products, whether late-adopters come in more slowly than early-adopters because of budget constraints, how quickly the untapped market grows, and a variety of other factors.

Whether you do this sort of modeling with a spreadsheet or with differential equations, you'll get essentially the same results. Specifically, growth rates are always a declining function of market penetration. Most strikingly, the growth rates begin to come down hard even at the point that a company hits 20-30% market penetration. Network effects accelerate the early growth, but also cause growth to hit the wall more abruptly. Replacement helps to accelerate the early growth rates too, but ultimately has much more effect on the sustainable level of sales than it has on long-term growth. In fact, if the replacement rate (the percentage of existing users that replace their product each year) is less than the adoption rate (the percentage of untapped prospects that are converted to new users), it's very hard to keep the growth rate of sales from falling below the rate of economic growth.

The key point is that growth rate falls off a cliff as market share (penetration) increases. This is essentially the cycle of business, whereby companies start with nothing and capture ever greater market share, while their growth rate slows. To illustrate his point, Hussman generated the following scatterplot of several high-growth companies from the 90's (Microsoft, Cisco, Intel, Oracle, IBM, Dell and Wal-Mart):

(source: Hussman Funds Weekly Market Comment, April 30, 2012)

A nicely declining (possibly exponential) curve; the data almost fits the curve perfectly.

If I'm not mistaken, the revenue growth will approach nominal GDP growth rate if the industry was large and representative of the economy. In the long run, US nominal GDP growth is around 6% (basically 3% real + 3% inflation) so sales growth should approach that (someone correct me if I'm mistaken on this). However, this is influenced by numerous factors and many mature companies can barely grow beyond inflation (many very-old industries like agriculture, railroads, and utilities grow very close to inflation).

One of the superstar growth stocks right now is Apple and John Hussman suggests that investors may end up being dissapointed:

...in order to maintain even a constant level of sales, every unit sold in a given year has to be matched by a replacement the next year - year-after-year - or it has to be matched by a new adoption, and adopters of used products don't count. Simply put, even zero growth demands that every dollar existing users spent on Apple products last year has to be spent again this year, or matched by some new user this year, and then again next year, and again the year after that, ad infinitum. Of course, it's reasonable to expect that late-adopters (e.g. those who have to save in order to afford the product) will have lower replacement rates, which will need to be offset by even greater adoption. Yes, there are billions of people in developing countries without an iPhone. Unfortunately, most of these people are also without running water.

We've seen very rapid adoption rates, very high replacement, and very strong network effects in Apple's products. All of this is an extraordinary achievement that reflects Steve Jobs' genius. I suspect, however, that investors observe the rapid adoption and very high recent replacement rate of three very popular but semi-durable products, and don't recognize how improbable it is to maintain these dynamics indefinitely. Despite great near-term prospects, within a small number of years, Apple will have to maintain an extraordinarily high rate of new adoption if replacement rates wane, simply to avoid becoming a no-growth company. That's not a criticism of Apple, it's just a standard feature of growth companies as their market share expands. It's something that Cisco and Microsoft and every growth juggernaut encounters. Apple is now valued at 4% of U.S. GDP, but then, Cisco and Microsoft were each valued at 6% of GDP at the 2000 bubble peak. Not that things worked out well for investors who paid those valuations. There's always the hope that this time it's different.

The products Apple sells are almost-necessary and is valued by customers so I think companies like Apple can get customers to replace their products. So, it's not as bad as it seems. However, the growth rate will definitely decline. As Hussman points out, Microsoft and Cisco's market cap were 6% of GDP in 2000, and Apple is 4% of GDP right now.

I've been somewhat bearish on Apple for years and been completely wrong. But then again, contrarians like me always get the growth stocks wrong. However, people like me tend to be right on any trip down the hill. People investing in companies like Apple better be confident of Apple's moat and its ability to maintain profit margins.