Buffett spins a sorry yarn

Has the Sage of Omaha lost his marbles? This is the question raised by comments made at Saturday's annual meeting of the Berkshire Hathaway investment company by Mr Warren Buffett, the company's chairman. In the course of defending his worst-ever annual returns to investors, Mr Buffett trashed the Internet with all the wit he has become famous for.

But he made some more serious observations too. "For society, the Internet's a wonderful thing but for capitalists, it's probably a net negative," he claimed. He described it as a process of "wealth transfer", not creation, and said that the ability to compare prices was driving margins down and diminishing the value of US businesses.

A closer look suggests that two separate changes are taking place.

First, the Internet is making businesses more efficient by cutting their costs and continuing the process of replacing labour with capital that began with the Industrial Revolution in the 18th century.

Services that allow investors to type their buy-and-sell orders over the Internet will put out of work people in brokers' offices who take phone calls from customers and do the typing for them. This is analogous to the spinning machine that Richard Arkwright patented in 1769, which spelt doom to the people who spun thread by hand in their homes.

In both cases, the change causes short-term pain and dislocation. In the long term, it may also reduce the number of people employed in the industry that changes. But a more efficient industry means that customers can buy more product for the same price, or can buy the same quantity and then spend their savings on other things whose production creates new jobs. That is why, in general, changes that allow industry to use less labour are good, not bad, in the long term.

It is only from the perspective of the businesses that are superseded, the hand-spinners, if you will, that the change looks like a transfer rather than a creation of wealth. As an avowed technophobe, Mr Buffett is clearly at risk of picking companies that are in this category.

Second, by stating that the Internet is driving down margins across industry and diminishing the value of US businesses, Mr Buffett has pointed to something that is more subtle.

The statement about margins is undoubtedly true: that the Internet causes prices to fall not just because the supplier's cost structure is reduced, but because shareholders have no choice but to accept lower margins as the competition is now only a click away.

In effect, this is a move towards "perfect information", the assumption made by economists in describing the behaviour of businesses and consumers, which used to look absurd. Once perfect information becomes a reality, one of the factors that lets businesses remain consistently profitable (contrary to the economists' prediction that competition should drive marginal profits down to zero) disappears.

Is this bad news for shareholders?

At first sight, yes, because canny investors like Mr Buffett have always liked businesses with high margins. But Amazon's gross margins in 1999 were a miserable 18 per cent, even before counting a sales-and-marketing expense that gobbled up the company's gross profits before any other costs.

But a closer look at Amazon's financials reveals an interesting point. In the last quarter of 1999, the company was bringing in annual sales of $2 billion (€2.2 billion) while requiring only $220 million in inventory and $318 million in fixed assets. The result: its return on capital, if the business can cut its marketing expenses after driving enough growth to fill its under-used 5 million sq ft of warehouses, could prove rather high.

This conclusion may be for the world as a whole. Businesses that emerge as winners from this global change will probably have low margins, but they will deliver value to shareholders that is as good as old economy stocks with big entry barriers and high margins, or even better.

It is hard to pick the winners: the more likely the bet, the less palatable the stock price. But if you take the Buffett view that the Internet is merely redistributing rather than creating wealth, you are less likely to find them. Berkshire Hathaway's shareholders are the poorer for his mistake.

Tim Jackson is founder of QXL.com and managing director of Carlyle Internet Partners Europe, a venture capital fund.