Un-superb businesses
Cow patties around the world of investing
In this post I propose to write about stuff and companies to avoid.
Let’s look at some of the signs to watch out for. These are in no particular order.
- Companies beset by the ‘institutional imperative’
One type of company to avoid is a company beset by what Warren Buffett calls the ‘institutional imperative’:
“ (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. 1998) p 96
Each of these points is worth dwelling on. Much of it revolves around management hubris and empire building. Remember, unless management holds the major part of their family net worth in shares of the company there is a serious potential agency problem.
As to being driven to do the same as peer companies, I’ve seen this happen with Canadian banks. Because banking in Canada is an oligopoly, our banks generate excess capital. But they have few opportunities to reinvest this free cash flow in growth of their core banking businesses. So, periodically one of them will make an acquisition in a lower ROE near sector such as investment banking or insurance and even in U.S. banks, or heaven forbid, in a developing market like the Caribbean or South America. When one does it, they all follow suit like sheep. This is the mindless imitation Buffett is referring to.
- Diworseification
Investors should avoid ‘diworseifications’ as Peter Lynch puts it. He notes that: “Instead of buying back shares or raising dividends, profitable companies often prefer to blow the money on foolish acquisitions.” (Lynch, One Up on Wall Street. 1989,1990) p146
This flows from much the same kind of management thinking as Buffett’s institutional imperative.
Wall Street mostly hates acquisitions, mergers or diversification by companies. They create instant uncertainty. The most hated are the so called ‘transformative’ acquisitions. These are major transactions that may send the company on a new path. The Street does not mind the so called, ‘tuck in’ acquisitions that round out product lines or give existing products access to new markets, and so forth.
The issue is appropriate allocation of excess capital, an issue that Warren Buffet has opined on many times. If a company generates significant free cash flow but has few opportunities to invest the money in real growth opportunities in its core business, many CEOs let the excess capital burn a hole in their pockets and embark on ‘diworseification’.
There is a flip side. As Philip Fisher notes, a company embarked on an acquisition can often present a buying opportunity. Once a large acquisition has been announced the stock will frequently sell off. Even after the closing of the acquisition transaction, the stock may remain depressed for a period of time as the street waits to see if there are integration problems.
Here is where the investor’s independent judgment must assert itself. Is the acquisition going to be a disaster with huge write-offs a few years down the road or is it going to prove its worth? The point is that one should be extremely skeptical of acquisitions but also recognize they may present opportunity. One can be more confident if the CEO is the founder of the company and has hundreds of millions of dollars of his own personal net worth tied up in the stock.
By the same token, one should be more skeptical if the CEO is a career executive making his best money from rich severance packages.
- Distant Future Obligations
Companies with obligations to provide something in the distant future with no idea what it will cost. An example of this comes from the life insurance industry. It actively promoted and sold variable annuities and universal life with lifetime low-cost guarantee provisions. Some companies have come to grief with these products.
- Hottest stock
Peter Lynch says: “If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train – and succumbing to the social pressure often buys.” (Lynch, 1989,1990) p141
- Concentration
Peter Lynch reminds us to be wary of the company that sells 25 to 50 percent of its wares to a single customer. This caution can be expanded to single product or limited range of product companies and other concentration risks.
- Chasing the next Magnificent Seven
One of the dreams of many investors is to find a company that has been started in a garage or dorm room, get in on the ground floor with an initial public offering and ride the stock as the company grows to a profitable multi-billion-dollar enterprise. It can’t be done. The chances are about as good as winning a huge lottery. Nor is it necessary. The intelligent investor will stick with solid profitable companies.
- Companies heavily dependent on research
In January 2000, twenty-three years ago, the ten largest capitalization companies in the S&P 500 were Microsoft, Cisco Systems, Exxon Mobil, Intel, Citigroup, IBM, General Electric, Oracle, and Home Depot. They were the Class of 2000 mega-caps.
Half of these companies are in the digital technology sector. Only one, Microsoft, is still at the top of the market cap heap. It successfully renewed itself. The four other tech companies have faded. One of the problems is that each of the four was heavily dependent on research to stay at the front of the pack. The problem with technology is that the world is changing rapidly. Technology companies can be displaced by new technology.
The large pharmaceutical companies fall into this category as well. They are research dependent. They are constantly having to come up with new drugs. Warren Buffett has popularized the notion of moats. Pharmaceutical companies have patents. These are not moats because they expire.
- Companies that need continuous massive capital investment
Under a heading titled, ‘The Great American Jam Tomorrow Ponzi Scheme’ Train summarizes: “For me, Buffett’s most important single message is his cry of alarm and recurring admonition to steer clear of the standard big American heavy industries requiring continuous massive investment. Most of them are in trouble. The cause is competition, overregulation, rising labor costs, and the like.
The symptom is that just to stay in business many of these big industries need more money than they can retain out of reported earnings after paying reasonable dividends. To stay in the same place, they require endless infusions of net new cash, like India and Egypt. To be sure, there are dividends on the new stock and interest on the new bonds that they constantly issue, but basically these dividends and interest payments are only a loss leader to induce the investor to buy the new securities being issued. He has only an outside chance of ever seeing his principal again in real terms. ‘Jam yesterday and jam tomorrow, but never jam today.’” (Train, The Money Masters – Nine Great Investors: Their Winning Strategies and How You Can Apply Them. 1980) p39
Prior to 1980, Buffett anticipated the 2009 insolvency of General Motors and Chrysler!
Fisher did not dismiss capital intensive industries as Buffett seems to have. The drawback to these industries is the cost of maintaining and upgrading expensive equipment.
On the other hand, Fisher points to situations where inflation can enormously increase the cost of new plant and, if overcapacity such as existed in the cement industry after World War ll, suddenly changes to under-capacity, the existing operators can reap tremendous profits. Buffett, ever flexible, may have used this approach and considered the built railway networks an unusual opportunity when Berkshire bought shares in Burlington Northern Santa Fe. (Train, 1980) p79
- Putting the whole company on the line
Companies which occasionally have to ‘put the whole company on the line just to stay in business’. The company that came to mind when I originally thought of this was Canada’s Bombardier and its new passenger jet a few years ago. The development costs for the jet were so high that failure of market acceptance for the jet could prove fatal for the company. An interesting comparison was United Technologies before its merger with Raytheon. It developed and brought to market a new geared turbo fan jet engine. Because of its size the company did not put its future on the line with the new engine. If the program had been a failure, it would simply have put a ten-billion-dollar dent in United Technology’s balance sheet. It is noteworthy that the successful introduction of new technology can give a company a technological lead over its competitors. The lesson here is that there is sometimes a fine line between committing to continuous research and development to maintain a franchise and betting the company just to stay in business. The lesson remains that having to put the whole company on the line is something for investors to stay away from.
- Debt burdened companies
This one seems quite obvious. In a rising interest rate environment debt is particularly pernicious. Think here of REITs and utilities where high debt is part of the business model.
- Chain letter companies
This refers to companies with geometric growth requiring more and more cash. Some investors become mesmerized by rapidly growing sales. They assume profits will follow. If the growth absorbs capital faster than it produces Free Cash Flow, warning lights should be flashing. It a company has low margins on its sales, doubling its sales may not increase its margins.
- Concepts and themes
Concept stocks are those with some brilliant idea that could reach an addressable market of billions of dollars. All they need to do is capture 5% of that market and the shareholders will be rich. It’s a sure way to lose money. Themes are another beguiling idea. One classic theme is demographics. Another is serving the low carbon economy. Similar is liking a product, say a car or a smart phone and thus thinking the company a great investment. The problem is that we take investment shortcuts. We invest in the concept or the theme and not in the company. Kahneman tells us that the shortcut “sometimes works fairly well and sometimes leads to serious errors.” (Kahneman, Thinking, Fast and Slow. 2011) p98 It’s called the Affect Heuristic.
- Commodity businesses
Buffett has always disliked of ‘commodity’ businesses. These would include not just resource extraction businesses but any business in which a company’s products or services are essentially indistinguishable from those of its competitors. One can include computers, smart phones, automobiles, airline service, banking and insurance in this category.
Never say never. For every rule there is an exception. Today or in the recent past, Berkshire has investments in a Chinese auto company, an airplane leasing company, banks and insurance. In fact, Wells Fargo and GEICO are major long term Berkshire holdings.
Wells Fargo, before it stumbled, was superbly managed which may have allowed it to build a stable and enduring franchise. GEICO which is a core Berkshire holding has a business model which apparently gives it an enduring cost advantage.
- Management spinning you a line
This means not so much outright lies but management given to sales pitches rather than frank and honest explanations in shareholder communications such as press releases, interviews, quarterly reports and annual reports.
Conclusion
It’s all too easy to invest your money in big well-known companies, the household names, without really understanding their business. The message of this post is that we invest in businesses. We must understand both the strength and weaknesses of those businesses.
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I’m also on Twitter @rodneylksmith
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