Unpredictable Businesses and Their Perils

 Unpredictable Businesses and Their Perils

The departure from an operation is likely to be significantly more gradual than what an impartial observer would have anticipated whenever a significant investment has been made in that sector, once there is a lot of money, people, and pride associated with that operation.

When you're an investor, it's simple to step back and view a company through the eyes of a logical capital allocator. However, only a small fraction of the workforce possesses the strategic vision necessary to see the big picture. They can't look at the situation objectively. Jobs are on the line. There is the recognition of failure. The issue of one's own identity also arises. Equally critical is the fact that these issues plague the management on a daily basis. Being stuck in a failing firm for too long is usually not due to a single big mistake, but rather a chain reaction of small ones that add up and make the inevitable worse.

It is not easy to acknowledge the dreadful significance of the rigidity of a company that is bound to a specific industry, production method, or workforce. This trap has snared a lot of value investors. While some companies may seem to be offering great value right now, they will lose all of that value if they stick to their old ways. We'd all love it if managers could just detect the looming threat, fix it, and transform the company for the better before it happens. However, a leap of faith is necessary for that type of thinking. Investors have a tendency to believe what they want to believe, like the idea that tomorrow will somehow be taken care of.

A someone as careful as Warren Buffett about staying out of companies with bad economics for as long as possible has fallen prey to illusions of an easy transition. Throughout his career, Buffett likely shown three instances of similar delusions. Just two will do (the third being the Hochschild-Kohn department store in Baltimore).

Late in 1993, Buffett had his most recent illusion. When Berkshire Hathaway bought Dexter Shoe, it was then. It was a mistake, Buffett now knows. He composed the following for the 2001 annual shareholder letter:

I first bought Dexter, then paid for it with stock, and then put off making improvements to its operations even though it was clear that they were necessary; all three of these choices have severely harmed you.Both before and for a while after our purchase, Dexter thrived in the face of ruthless, low-cost competition from abroad. I thought Dexter could handle that issue on his own, but I was mistaken.

Buffett enumerates three distinct choices. I fail to see his handling of the Dexter Shoe scandal as a mere careless arrangement. Buffett is now acknowledging that he was completely wrong to purchase Dexter Shoe. Neither stock nor cash should have been used to purchase it.

A fallacy in reasoning led him to make that buy. It wasn't as simple as paying too much (with shares). Moreover, his third choice—"procrastinating when the need for changes in its operations was obvious"—is worth mentioning. That's an honest confession, I must say.

Procrastination is a decision, according to Buffett. Even if it wasn't a one-time decision between two pathways, it was still a costly decision that had to be made every day. In business, it's typical to justify doing nothing as a lesser evil than doing something wrong. This approach fails to teach us anything. In the investment world in particular, inaction deserves the same severe scrutiny as action.

The most intriguing aspect is how Buffett distinguishes the acquisition from his inaction in demanding reform at Dexter Shoe. He makes no indication that attempting to buy the company and make changes would have been a good strategy. It appears like Buffett is implying that the wisest move would have been to stay out of the business altogether.

I believe he is correct. It is tough to put a price on the dangers associated with buying a rigid company. Be that as it may, they exist. When these dangers are substantial enough, they can wipe out any bargain-basement value that derives from strong present earnings (or cash flow).

A company bought for its cash flow potential may turn into a money hole in no time. The customer is usually fully cognisant of this danger. But he persuades himself that the change will happen quickly enough, thanks to his logical analysis of the facts and his drive to maximise the return on investment.

Things are seldom seen so clearly by operating managers. There is usually a lack of determination even when the way forward is obvious. We tend to rationalise judgements that appear to provide a medium ground. An enticing possibility is always a slow shift. Assuming a retreat is actually a fighting withdrawal is something that everyone wants to do.

Buffett explained Berkshire's decision to stay in the textile industry for so long in the 1985 annual letter to shareholders:

"(1) Our textile businesses play a significant role in their communities as employers. (2) Management has been candid about issues and has taken proactive measures to resolve them. (3) Labour has been supportive and understanding in dealing with our shared challenges. (4) The business is expected to generate modest returns on investment."

I was completely mistaken regarding (4), as it proved out.In order to boost our corporate rate of return by a small margin, I will not shut down a business that is not profitable at all. On the other hand, I don't think it's right for a highly lucrative business to keep funding a venture that seems doomed to perpetual losses.

Buffett was only deluded about his fourth justification for staying in the textile industry. The allure of a mediocre firm lies in the expectation of modest returns.

A more reasonable interpretation of the evidence would have produced a different result. Looking forward to potential future profitability due to improving industry circumstances and higher efficiencies is rarely a surefire recipe for financial success, according to historical data. Optimism persisted. Nevertheless, evidence of the validity of such optimism was infrequent.

We could have reduced our variable expenses to some extent over the years by investing heavily in the textile operation. All of the suggestions to do so seemed to have a clear advantage. By conventional measures of return on investment, these plans frequently offered more financial gain than would have been possible with the same investments in our very lucrative confectionery and newspaper companies...The gains that were supposed to come from these textile investments, however, never materialised.

The arguments put up in favour of these investments were flawed, as any impartial observer would have noticed. An excess of capacity was a major problem for the industry. A massive influx of funds was misdirected into an apparently promising business due to a horrific misinvestment of capital in the past.

That money was sadly not put into assets with a high rate of return. The owners were burdened with enormous fixed costs as a result of the massive spending. There is nothing worse than a factory that doesn't create anything at all. A money pit, that is. There are really two options for the owner: either get out of the company or do whatever it takes to get the best variable costs. No one will have a good time if a majority of participants choose option (b).

"When a sufficient number of our domestic and international competitors made similar investments, their lower costs set the standard for price cuts across the board. The capital investment decisions made by each company seemed reasonable and cost-effective when seen in isolation, but when taken as a whole, they were illogical and had the effect of cancelling each other out, like when spectators at a parade decide that standing on tiptoes will help them see better. All the players had more money in the game after each round of investment, but returns remained anaemic.

Investors would do well to recall the mental image of a swarm of people watching a parade on tiptoe. This is the hallmark of a poorly run company. You should stay away from this type of investment. Companies almost seldom get out of a firm on good financial terms. It takes its sweet time, far after the inevitable fall has become glaring.

Businesses that are too rigidly bound to one industry, production method, or workforce are called inflexible. You would be surprised at how unrelated these are to most companies.

Some are. Two examples from the recent past are Xerox and Kodak (EK). The workforce of General Motors (GM) is rooted in a different time and place. General Motors exemplifies the type of rigid company that is bound not just to a specific sector but also to a specific niche within that sector. The business was not set up to reduce its operations in the case that it lost market share. Alterations to the composition of a company's target market can have as equally devastating effect on certain companies as technological advancements.

Bad things can happen as a result of these changes. The bright side is that businesses that could be vulnerable to these potential dangers can be easily identified. Unions were prevalent in the massive General Motors workforce. Quite a bit of the American market belonged to it. Keeping its market share was obviously crucial. Investors may not have considered that a few decades ago, when the thought of General Motors losing market share could have seemed ludicrous. But if they had given it any thought, they would have seen that keeping a sizable portion of the American market was crucial to GM's existence.

Microsoft (MSFT) and Intel (INTC) would also need to act swiftly and drastically if they saw a significant decline in their market share. Those businesses can't continue as they are with such a little portion of the market. Sure, laying off tens of thousands of workers would be a breeze for these companies compared to General Motors. However, rational investors do not purchase Intel or Microsoft stock unless they anticipate that these companies will keep their present product market shares.

The two companies are very focused on increasing their market share in the future. Their massive expenditures would make any competitor crumble under the weight of their industry dominance. Small armies are employed by the firms. The sum of these two corporations' workforces is equal to, if not more than, the number of American troops stationed in Iraq. So, it's obvious that both firms have staked a lot of money on maintaining their dominance. These responsibilities would become unbearable without such control.

Any company you put money into should have some wiggle room. The biggest threat to a big company is a drop in income that won't be matched by a corresponding drop in expenditures.

Because I've seen firsthand how simple it is to trust management blindly, the "will not" component is crucial. Making hard choices is unpleasant for everyone. Even if someone knows there's an issue, it doesn't imply they'll attempt to fix it just because it's clear. Many lawmakers in Congress are aware that the national debt is an issue, I'm sure of it. Furthermore, I am certain that they are aware that fixing the issue would be counterproductive to their goals. In their opinion, it should be handled by someone else at a later time. Absolutely everyone would.

Justifying a thousand little steps is too easy. So long as you don't own up to your one major error, you're good to go. Maybe nobody intends to bind a company to a rigid and possibly dangerous stance. Similarly, it's possible that nobody actively decides to keep going in that direction. However, it usually comes to pass in such way. By the time the owners realise they need to fix the issue, it will be too late. The monetary and time costs are already too high.

Consequently, it could be wise to seek out companies where managers won't have to make difficult judgements. No matter how solid the fundamentals are, investing on the hope that management will make difficult decisions has an inherent risk.

Location:

Share :