Efficiency Gains - Blessing Or Curse For QQQ?

The tech index as measured by Invesco QQQ Trust ETF (NASDAQ:QQQ) is up 23% year to date, primarily driven by 2 factors:

1. Ten year treasury yield is down.
2. Efficiency improvements are driving earnings.

The first reason is legitimate and financially correct. The 10-year treasury began the year right around 4% and now sits at about 3.5%.

Most of the index runs light on debt, so the QQQ doesn't care that short term interest rates are still very high. Instead, the main driver here is discount rates.

Since this is among the growthier indices with relatively low earnings yield today, it has a higher duration than most other equities. Thus, the weighted average cashflow is further into the future which means more years of discounting to get to present value.

In academic theory, higher interest rates hurt all equities because it means the discount rate is higher so the present value of everything is less. Higher rates disproportionately hurt the QQQ because of its longer duration. Discount rates tend to be driven by the 10 year treasury yield with some risk premium added on top, so the 10 year yield moving from 4 to 3.50 so far in 2023 is a huge boon to tech and explains at least a portion of QQQ's year to date outperformance.

As far as I can tell, that portion of the move is correct.

The rest of the outperformance seems to be driven by rather substantial earnings growth driven by efficiency gains. So far this is taking the form of mass white collar layoffs. The idea is that with improved technology the companies can fulfill all the same functions with fewer people. The most pointed to factors seem to be:

• Greater processing power
• AI
• A population that is much better versed in coding than it used to be

Simply put, most things in the information services industry can be done faster and cheaper than previously.

These layoffs and similar cost cutting measures have already significantly improved earnings across much of the index. On the surface, that would seem like a fundamentally rational reason for the index to rise in price.

However, I would caution in considering these cost savings to be a permanent increase to earnings.

Efficiency - a blessing or a curse?

History has taught us that efficiency gains do not always translate to durable earnings growth. There are thousands of examples one could use, but I want to look at one where efficiency results in greater productivity and one in which efficiency is of the cost saving nature.

The greater productivity effect On Farmland

When the weather hits just right in a given year, farms will operate more efficiently resulting in well above normal crop yields. Without any additional cost, the farmers produce significantly more so it seems like a good thing at first, but when it happens, commodity prices tend to crater.

Farmer revenue is the product of yield X price, so while yields are up price is down and it is unclear if that is actually better. Efficiency gains are often akin to a supply surge. In the case of weather, the supply surge is temporary resulting in a temporary glut of supply, but if it is more technological in nature, say better plant genetics or superior fertilizer, the supply glut is more secular in nature.

Cost savings style of efficiency

There have been many efficiency improvements in personal computing. Back in 1981, a computer looked like this.

It was an IBM Personal Computer 5150 and according to USA Today this one would have cost $1,565 which adjusted for inflation would be about $4,332 today.

Over the years, technology improved significantly. Chip makers automated production making better chips faster and cheaper to produce. The cost savings once an automated chip factory was up and running were huge.

This probably seemed like it would be good news for PC makers, but once again the efficiency gains went to consumer surplus instead of producer surplus.

Today's computers are 100X better and 1/10th the price. The consumer won and many of the major desktop computer makers went out of business.

Thus, my initial read is that the market is being far too hasty in pricing in the efficiency associated with the tech job cuts as a permanent gain to earnings. Much like the employee who trains a robot to do his job winds up unemployed, not all efficiency winds up being good for the industry.

Profit increasing efficiency versus profit reducing efficiency

I believe the key differentiator here is whether the efficiency is unique to a business or if it is industry wide. Industry wide efficiency gains have one or more of the following effects:

• Price reductions on sold goods or services
• Supply increases
• Reduced barrier to entry
• Reduced replacement cost

None of these are good for incumbent businesses.

In contrast, when a company has its own unique source of efficiency, it gets the cost savings or production increase without its competition observing the same. That sort of efficiency truly does lead to sustainable earnings growth.

Consider the early days of Walmart (WMT) in which it built out a hub and spoke logistics model. At that time, it was the only company with such efficient distribution and it outcompeted everyone. Huge gains from the company specific efficiency advantage.

What does this mean for the QQQ?

Well it depends on whether one believes the efficiency gains seen in 2023 are company specific or industry wide.

I am of the belief that they are industry wide. It wasn't just one company that used a newfound efficiency to lay off 10% of its employees. It seems to be across the board.

According to Forbes, already by February 24th, 2023:

"400 tech companies have laid off over 110,000 white-collar professionals."

That, in my opinion, is not a specific company finding a unique source of efficiency gain. That is an entire industry that has found a way to do things more efficiently.

So what happens?

Well, the cost savings are immediate. They are already showing up in 1Q23 earnings reports and full year 2023 guidance. It is this earnings rise that has caused the aforementioned outperformance of the QQQ.

Over time, however, the negative effects of industry wide efficiency will start to kick in.

For the subsectors that sell goods or services, I would expect the supply of those to increase which will in turn reduce the prices companies can charge.

It is a bit trickier for companies that already charge $0 for their product but instead sell customer information to advertisers. I don't see the increased efficiency leading to advertisers paying less for ad space.

Instead, I think the industry wide efficiency gains will manifest as reduced replacement cost. It is rapidly becoming cheaper and faster to create a competing platform. As such, competition is a greater risk and I think there will have to be increased spending to maintain market share.

• Can Google (GOOG) maintain 90% of search market share with open source programs providing deeper answers to certain types of questions?
• Can Apple (AAPL) maintain 2 billion ecosystem users if competitors can produce increasingly equivalent phones at a much lower price point?

I don't know the answers to these questions, but I do think the market should be a bit more cautious about pricing in the widespread layoffs as permanent earnings growth.

That which can be produced cheaply, tends to be sold cheaply.

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