Archives For Mad Men MBA

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

Charlie Munger (as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

 

 

A reader and I shared a recent exchange about the quote above. I thought it was worth sharing some of the thoughts on the blog. Here you go…

Continue Reading…

MadMen MBA

Doug wanted to get me watching the AMC hit series Mad Men and so proposed a series of case studies on companies featured on the show. He had me at case study. Thus was born the Mad Men MBA, a collection of articles exploring the strengths and weaknesses of the businesses being pitched by the admen at fictional Sterling Cooper Draper Pryce.  We conduct our analysis based on a four-part framework, (“for really understanding companies”) outlined here. In the end, we try to make this a practical exercise, estimating a reasonable price for buying the business and deciding whether it’s a worthy investment today.

Our first case is H.J. Heinz, Inc. (HNZ), the undisputed champ in today’s ketchup market and a key account Don Draper and crew were trying desperately to retain in season five of the show (representing the early-1960’s).  In episode five, At the Codfish BallJack Heinz is preparing to take his lucrative Heinz Baked Beanz marketing budget to another ad agency. Draper’s young wife catches wind of the defection while powdering her nose with Mrs. Heinz at a dinner meeting, relays the tip to her husband, and sets up a dramatic ad-man pitch to keep Baked Beanz with Sterling Cooper Draper Pryce.

Today baked beans is a big business for Heinz in the UK market but has much less importance globally. The big brand is Heinz Ketchup, providing over $5 billion of its $11.6 billion in 2011 sales and with a global market share close to 60 percent.

Doug sets up the case study in a recent email:

Heinz’s big challenge was defining itself after pure domination in the baked beans market. They were friends to the military and the ease of packaging their product for wartime solidified their position. But they also had the vision to know they needed to branch out into new product territory, especially in times of peace. Ketchup became their big push and more than the product their packaging became signature. Pounding of the glass bottle to get it started and even when it pours out, it is all good. You can never use too much ketchup.

That was the 1960’s, let’s bring it back to the Heinz of today using our four-part framework for understanding businesses.

Continue Reading…

MadMen MBA

My friend Doug is on a mission to get my wife and me watching Mad Men. It would seem we’re the last denizens of earth still holding out. His latest tactic has won me over. Doug has proposed using the various companies featured in each episode as case studies for the good, the bad, and the ugly of businesses. He had me at case study. 

So what he proposed with such friendly intent, I’ve expanded with a barrage of verbosity. I’ve agreed to his proposal (and we’ll borrow his box set of seasons 1-4), and countered with this suggestion that we employ a specific framework for our analysis, one that I use for investment valuations and that I believe forces you to truly understand a business. 

For these purposes, I’ve dubbed it the Mad Men MBA, and below is the framework I proposed via email.

Provided it doesn’t send him running for an escape, perhaps we’ll feature one or two of the case studies in a Mad Men MBA series here on pauldryden.co. 

Ok, Doug, let’s up the ante on the Mad Men MBA discussions. When evaluating any business, whether to invest in it or just to understand it a bit better, it helps to have a framework. A framework organizes your thoughts, lets you sift through the information in a systematic way, and gets you pretty close to making valid comparisons between companies. Without a framework you can pick up bits and pieces of what’s good or bad about a company, but unless you have some way to organize all the information you’re taking in…it tends to float around in disconnected ways. That’s how it works for me at least. A framework helps me retain information, shift it around while looking at its different angles, understand it deeply, and ultimately turn it into a base of knowledge I can build on.

The great hope is that accumulating knowledge can eventually lead to wisdom. Sweet, sweet wisdom.

So, grasshopper, here is my suggestion for a framework, posed in the form of questions to ask about each company featured on Mad Men…

Continue Reading…

Profits are good. And our profitability bias – that preference to own, to cover, to work for, to partner with companies that turn a profit – is a pretty good filter to apply when evaluating a business for whatever reason. But the best companies sometimes forego profit in the short-term, investing capital more heavily than perhaps is absolutely required or plowing back what might have been profit to increase their expenses in certain areas that provide advantages over the competition.

It’s not as if they don’t recognize that everyone prefers they were profitable. It’s that they understand that delaying the gratification of immediate profits, when those dollars are spent wisely on honing the defenses of the business, can lead to much greater profits down the road. And, more importantly, it can lead to profits that are protected against the encroachment of bigger-smarter-richer competitors that want nothing more than to steal away its customers.

Profits can be very nice, but they do not necessarily make for the best businesses.  The best businesses couple profitability with sustainable competitive advantages that protect future profits. And when a dilemma requires companies to sacrifice either profits or competitive advantages, the best ones watch out for their long-term interests. They sacrifice profits and keep investing in their defenses.

Of the major categories of competitive advantage – strong brand, legal protection, captive demand, and scale – the one with the longest lasting benefits is scale. This is where the size and efficiency of your operations allow you to produce an offering for less than your competitors, so much so that no rational actor would dare attack your position.

When combined with other forms of competitive advantage, scale makes for the deepest defenses of all.

The Curious Case of the Coca-Cola Secretary

In late-2006 a secretary at Coca-Cola headquarters conjured up a lurid plot. Working with two ex-convicts, she contacted arch-rival Pepsi and offered Coke’s most sensitive trade secrets in exchange for large sums of cash. The cabal believed Pepsi would be eager to steal a glance of secret Coke recipes, that such information would somehow help the competitor in its never ending battle with Coca-Cola to win the cola wars.

Pepsi wasn’t so keen on the scam. In fact they called up the FBI immediately and were glad participants in an exciting sting to catch the crew in the act and send them away on federal charges. Besides questions of basic human decency, why would the Pepsi executives not be eager for the patented trade information offered up by the secretary?

At best, the secret Coke recipe is one part honest-to-god competitive advantage based on a particular mixture of ingredients to produce a specific taste. And it’s nine parts marketing ploy, a wink at its audience to suggest Coke is so delicious that the company must keep the secret recipe behind locked doors (lest a competitor produce a beverage with the same flavors and thereby steal away all its customers, of course). The public loves the mystery that comes of a secret formula!

Coca-Cola’s competitive advantages are far less grounded in the legal protection of patents and formulas defended as trade secrets than they are a potent combination of brand and economies of scale. The company has spent billions over the years on savvy marketing, creating a Pavlovian tie between the sound of fizz escaping from an opened bottle and a person salivating in anticipation of her refreshing drink. But more importantly, they have made the product omnipresent. You are probably never more than a few steps away from the opportunity to buy a cheap Coke the moment the urge hits you, whether that urge is induced from a commercial or your own thirst.

This is an example of scale applied to distribution. Its products are everywhere, and making that happen is a far more impressive business feat than inventing a tasty carbonated beverage in the basement of an apothecary’s shop.

Coca-Cola has the benefit of scale in production costs, advertising, and distribution. They can produce a mind-bending amount of product for mere pennies per unit, with all the fixed costs being spread across  enormous production volumes. They can then buy national and international ads, reaching consumers all over the globe, inculcating them on the idea that Coke is it. And their distributors move tons upon tons of cases each day, spreading the cost of stocking shelves over all those bottles.

The benefit of investing to create all this scale means Coke can charge a pittance for each bottle of product, a dollar or two that most consumers will never miss, while still turning a very tidy profit. What would it take for a competitor to make a reasonable return at a comparable price point? Richard Branson tried in the mid-1990’s with Virgin Cola, even pricing below both Coke and Pepsi in hopes of stealing only a sliver of their customers. The cola incumbents ramped up their advertising budgets in every market they thought Branson might have a reasonable chance of establishing a toe hold, and they leaned hard on their customers to keep shelf space off-limits to the upstart. Branson couldn’t even get most grocery stores in his native UK to give his drinks a shot. When you can’t gain entry through basic distribution channels, you must know your future is grim. Price doesn’t even matter.

Any other competitor would run into the same challenges trying to surmount the advantages provided by Coke’s scale. As a last resort of scale, Coke could always fall back to its balance sheet – it has plenty of cash – and fight a price war to makes its products much cheaper than any alternative, gladly exchanging short-term profits to ensure it maintained long-term advantages. The profits will come back if the defenses remain strong.

And so we get a good chuckle out of the misguided secretary, hoping to make a buck selling Coca-Cola’s most valuable secrets. In reality, Coke’s competitive advantages are hidden in plain sight.  A big piece resides with its brand…but the bulk sits with its scale, the end-product of years of foregoing billions in additional profits in return for high volume production capabilities, wide reaching advertising, and a scaled distribution infrastructure.

Sometimes it makes sense to deny the profitability bias, the investor’s case of the Marshmallow Test, deferring the instant gratification of today to invest in defenses that promise even greater profits in the future.

Building those defenses is making investments in your competitive advantages, the bulwarks protecting your customers, your revenues, and your profits (current and future) against bigger-smarter-richer companies that want access to your market.

For the sake of simplicity, let’s say all competitive advantages fit under one of four umbrella categories: brand, legal protection, captive demand, and economies of scale.

For brand, just think Coke or Apple. These are the icons of their industry that have somehow (through tremendous investment in quality, consumer experience, and marketing over long periods of time) endeared themselves to their end-users in ways that I can only describe with the term “gestalt.” The whole is much greater than the sum of its parts.

The connection with customers transcends emotional. It seems almost spiritual. Or cultish, take your pick. For true Apple believers, you would have to pry their cold, dead fingers off a Mac keyboard before getting them to type a document on a PC.  Steve Jobs’ crew delayed profits for years and years as Apple invested heavily in engineering, design, elegant software, and lots of advertising. The totality of those investments contributes to the end-user’s experience of buying and using Apple products in ways bigger than any of those  investments considered individually.

Bigger-smarter-richer companies could not replicate Apple’s connection with customers.

For legal protection, think about pharmaceutical companies having patent protection over the molecular formulation of their drugs. For example, patents gave Pfizer years of exclusive rights to sell Lipitor to help American baby boomers reduce the amount of cholesterol floating in their arteries. It brought Pfizer as much as $13 billion of annual revenue at its peak, and plenty of profits to boot.

But let’s remind ourselves, those profits were the result of investments that lowered Pfizer’s overall profits for years before they peaked. The pharma giant invested hundreds of millions to develop the drug, patent it, win FDA approval to sell it, and then fight like crazy to defend and extend those patents.

We see the full impact of legal protection as a competitive advantage by watching what happened to Lipitor when its patents finally expired in November 2011. In about a month’s time, its market share was cut in half by generic competitors marching gladly past its now defunct bulwarks, selling their much cheaper alternatives to Lipitor patients eager for a lower pharmacy bill.

For captive demand, “sticky” has become the popular descriptive term to explain a service whose customers have a hard time putting it down once they start using it. Cigarettes come to mind, what with they being addictive and all. But my preferred example is the way banks have used online bill pay as a sticky feature that makes it an enormous pain to ever ditch your existing account for a competitor’s offer. Do you really want to trudge through the process of entering all your biller information, due dates, and payment schedules on another bank’s website? And for what? A free toaster with your new checking account? No thanks.

Finally, we have economies of scale, or just “scale” for short. The businesses best protected from bigger-smarter-richer companies have some combination of all four of the umbrella categories of competitive advantages. But the strongest have a healthy dose of scale, a trait that allows you to produce something for so much less than your competitors that the rational ones would see that it’s foolhardy to even attempt to compete with you and the fanatical ones – those that make an irrational decision to compete anyway – would run out of money before you.

We’ll dig more later on the benefits of scale…

Profits As Marshmallows

June 25, 2012 — 1 Comment

Let’s continue the thought from our last post regarding the profitability bias

Over the longer term a business must be profitable. Of course. But if it has the chance to be wildly profitable in the future with little chance of the bigger-smarter-richer company being able to steal its customers, perhaps those profits could be deferred for a time.

This is the business version of the marshmallow test, that Stanford University experiment from the 1960s popularized by Jonah Lehrer’s 2009 article Don’t from The New Yorker.  By way of brief recap, forty years ago Professor Walter Mischel brought four-year-old kids into a room for observation, offering each a simple choice: you could have one marshmallow now, a tasty-looking morsel set in tempting reach of your chubby fingers, or you could wait a few minutes and have two.

This was the ultimate test of the ability to delay gratification, foregoing the instant benefit to get an even better benefit in the future. If you’ve spent much time around young children, you’ll know that putting off pleasure does not come naturally to the vast, vast majority of them. This was Professor Mischel’s experience, too. Most kids gobbled down the tempting treat within seconds of the proposition being made. For those who held out, not only did they double their marshmallow bounty, but Mischel discovered their ability to delay gratification correlated even more closely with high achievement later in life than other more obvious factors like, say, raw intelligence.

Sometimes profits are marshmallows. We want that instant gratification of stuffing them in our mouths – getting that immediate surge of sugar energy – even though they could lead to even more profits in the future, profits that would be protected from bigger-smarter-richer companies trying to compete with us. If only we delayed our profitability bias for a time. If only we invested those profits into building and maintaining defenses for our business.

Next, let’s talk about what those competitive advantages are…

When thinking about business, we immediately let our minds wander to profits. Great businesses generate tons of profit. Of course, but we have a profitability bias in that we use it as an early measure of judging how good a business is. Does it bring in substantially more money than it must spend to buy its raw materials, build its products and convince you to buy them? If there’s money left over, it’s a profitable company. And the bigger the profits, the better the company.

And why would anyone argue with that? We like profits, and the profitability bias is not necessarily a bad one to have. When you’re using a framework to understand and assess businesses, it’s fair that you would want your checklist to include profitability. But like so many frames we use to understand complex and fluid systems, we do ourselves a disservice using just one, in isolation, without considering other important concepts as we scratch through the qualities the best companies must possess.

Profits are good. They are best when they can be sustained, and they are misleading when they cannot be sustained. Unsustainable profits can trick you into believing a company is more valuable than it actually is when you assume those profits will continue coming in or that they will compound over time.

But what happens if the profits go away? A bigger-smarter-richer competitor comes sniffing around, attracted by those tasty profits your business is showing, and decides it might like to get in the game. It decides to build the same product, but to build it better and sell it for less. And the bigger-smarter-richer competitor has the ability to do this.

Now those tasty profits are beginning to slip away as your company is forced to defend its market, spending more to earn each new customer, and pricing products lower to keep existing customers from deserting for the bigger-smarter-richer competitor.  Your business suddenly looks less valuable as the profits from yesterday don’t translate into profits tomorrow.

We need to check our profitability bias with another important concept that comes in handy when trying to gauge the quality of a business.

Enter the competitive advantage. That post is next…

Marc Beniof’s words (as noted in a post yesterday, here) sent me thumbing through a few more books in my library. What have other CEO’s had to say about their stock prices?

From the excellent book, Built From Scratch, by Home Depot co-founders Bernie Marcus and Arthur Blank, come the following quotes. (Which, by the way, in no way diffuses my enthusiasm for this book. When studying retail, it is as important to read this as Sam Walton’s Made in America. No question!)

The Home Depot has always been a high-multiple stock. Part of the explanation for it is that the financial community trusts us. (page 183)

Anticipating a hit to earnings from a bad acquisition in 1984, the early days, CEO Bernie Marcus went to the Wall Street throne to plead his case for not punishing the stock price:

 We arranged a series of meetings in New York in which Bernie and Ron Brill, every hour on the hour for a full day, came clean with fund managers and analysts who covered our company. Standing before each group, Bernie stood up and bluntly announced, “I am the CEO of this company, and I am a schmuck,” in precisely those words. “We screwed it up…”

After that, Bernie told them about the corrective measures that had been put in place to prevent a repeat in the future. He assured them that the growth and profitability would continue. And they believed Bernie.

 …We disappointed the Street for the first time…Suddenly, analysts said we didn’t know what we were talking about. It was the nadir of the business. (page 184)

Finally, the following quote calls into question whether the tail was wagging the dog. How much did attention from Wall Street influence their decision to expand in the Northeast? Don’t get me wrong. I understand that stock price plays a big role in a company’s ability to raise capital for growth needs. There is a reality to wanting the stock price to be high versus low. I get it. But the slippery slope of this mentality can be frightening.

 

During the first three years of our Northeast invasion [store expansion beyond its Southeast base], 1988-91, our stock just went crazy. Getting a presence to that part of the country exposed us to Wall Street in living color. For the first time, analysts and brokers saw how busy the stores really were. Seeing is believing; our stock price once again was climbing upward. (p197)

There is a disconnect here. It’s creating some serious cognitive dissonance for me. On the one hand, these CEO’s are smart and savvy. They don’t need a lesson in Stocks 101 from me…they understand that the stock price is not a direct reflection on the performance and/or promise of the business. I can’t imagine many CEO’s actually subscribe to the theory of efficient markets in which the stock price is somehow magically aligned with the true value of the business. No, they understand that the stock price is subject to whims, fancies, and misunderstandings of investors.

And yet, there’s this other hand. They keep playing to it. That makes sense in the Home Depot case from 1984 as they desperately needed capital to grow the business, and they saw the best source of capital as issuing new stock or new debt, both of which would be affected by the current stock price. If it plunged, their access to capital would be cut off.

I get that. I understand that when you need their capital, you’re hostage to the Wall Street game. You have to go to fund managers and analysts from time-to-time with hat in hand.

What I don’t get is that they often seem to be struck by the bug themselves. They tend to get caught up in the price, as if it were somehow the only scorecard by which they can measure their success as people in business. And worst yet, they allow (and perhaps encourage) their employees to do the same thing…to get excited by a rising stock price and to believe they are somehow doing something wrong when the price goes the other way.

That may be true some of the time. Sometimes (oftentimes even) the stock price does react to legitimate bad decisions by people in the company. But sometimes it just moves up and down, completely disconnected from the reality of the business.

I have no immediate way of understanding why many CEO’s do what they do. I’ll punt this discourse on the complexity of human psychology and just revisit the quote from Jeff Bezos that got it started (here). It seems wiser the more I think of it:

We have three all-hands meetings a year, and I’ll tell people that if the stock is up 30% this month, please don’t feel you are 30% smarter. Because when the stock is down 30% a month from now, it’s not going to feel that good to feel 30% dumber.

I didn’t intend this to be a series, but it has quickly turned into one. The original idea, from this post, is that holding up company managers as “shareholder friendly” (in that they do a fine job representing shareholder interests) can be like a backhanded compliment. Which shareholders, exactly, are they representing? Because it’s a certainty that few of the company owners share the exact same interests or desires for the business.

The most stark contrast might be between investors with an interest in the business showing short-term gains to impress the market, increase the stock price, and provide an opportunity to exit with a profit. They will want managers to work over their accruals as best as possible to show higher earnings. Or to just stop making investments in the business and let the lowered expenses generate a bigger bottom line.

Their objectives are not going to mesh with the investors hoping to stick around for the long haul. This group will not be excited by elaborate accounting to increase GAAP earnings. Nor will they want executives to neglect important expenses (like marketing, talent acquisition, research and development, etc.) in order to show a fatter profit next quarter. These expenses are investments in spurring growth and/or maintaining strong barriers to entry, both important in maintaining long-term profitability.

And even reasonable, level-headed investors can disagree with each other and therefore have diverging interests.

 

Case in point: Joel Greenblatt versus Michael Burry, a disagreement Michael Lewis brought to light in his book, The Big Short.

Joel Greenblatt, of value investing fame for his various books and tremendous track record with Gotham Capital, seeded Michael Burry’s hedge fund and benefited from multi-year period of impressive returns. Then Burry made his big bet against sub-prime lending, a complex and hard to understand investment, but one with a high likelihood of success (in Burry’s estimation at least).

Burry’s fund was down 18 percent in 2006. It was making his investors very edgy, and most of them – while being perfectly happy with his extraordinary returns in the years leading up to this – pushed him hard to ditch the strategy. As they threatened to pull their capital from him, he locked it up.

From the book:

In January 2006 Gotham’s creator, Joel Greenblatt, had gone on television to promote a book and, when asked to name is favorite “value investors,” had extolled the virtues of a rare talent named Mike Burry. Ten months later he traveled three thousand miles with his partner, John Petry, to tell Mike Burry he was a liar and to pressure him into abandoning the bet Burry viewed as the single shrewdest of his career.

Listen…there is a certain fog of war to these things. This stuff is not black and white. What seemed such a low-risk, high-return investment to Burry appeared quite different to Greenblatt. Perhaps Burry did a poor job communicating his ideas to the Gotham Partners. Perhaps the partners did a poor job listening. Regardless of the reasons, here we have two very intelligent investors and reasonable people disagreeing over how the money should be invested.

What is the shareholder friendly move in this dilemma? Should Burry try to liquidate his bets to give Greenblatt his money back? Not only would that go against a thesis Burry held with deep conviction, but it would ensure a loss as the strategy had not yet matured.

Or was the the shareholder friendly move the very action that Burry took? In other words, protecting Greenblatt against himself by locking up the money (no redemptions) and handcuffing him to the trade.

History tells us Burry was right. Greenblatt made off like a bandit by getting stuck with his former mentee. But this is just one example. I have no doubt there is no shortage of counterpoint examples in which hedge fund money is locked up, promptly lost (Philip Falcone anyone?), and investors are left holding the pittance that remains.

If reasonable, intelligent people (even value investors) can have diverging opinions and interests in a hedge fund example like this, surely the conflict only broadens when you have a wide base of investors in a public company.

So, what exactly does it mean to be shareholder friendly? Does it mean paying out a fat dividend to keep pension funds happy even when you have an expansion opportunity to plow that cash into growth? Does it mean cutting your marketing staff during a down turn because you know your margins will be pressured and you don’t want to disappoint Wall Street with a down earnings period? Does it mean cutting off a research initiative after two years of losses when you have high conviction that it will pay off in a big way if you just suffer another two years of losses to get it going?

*****

I’m a big fan of Joel Greenblatt. His books have helped my thinking tremendously, and he is serving an important role as he spends time educating people about his investing methods. And while I use the story of Michael Burry to illustrate my point, I want to make sure Greenblatt has the chance to make his case.

He did so in an October 2011 presentation to the Value Investing Congress (courtesy of Market Folly here).

In a Q&A Greenblatt was asked about Lewis’ account of events. His response was witty (and I suspect true), but more importantly he provided some balance to the whole affair…

Michael Lewis has never let the facts get in a way of a good story. What they got wrong in the book is Burry wanted to side pocket both mortgage and corporate CDS… we did not want him to side pocket the liquid corporate CDSs … only reason we took money from him was we were getting redemptions.

Greenblatt was not the unreasonable ogre Lewis made him out to be. He had his own pressures. This doesn’t contradict my point. In fact, I think it strengthens it. Sometimes a manager must be able to ignore the panic of his investors. He just might be protecting them in the long-run by sticking to his strategy despite their immediate needs. We know this happens in publicly traded companies, too. Large investors (hedge funds, pension funds, mutual funds) get calls for redemptions that force them to sell their holdings to generate cash to pay out departing investors. They must sell irrespective of the investment prospects.

The CEO of a publicly traded company can’t, of course, stop investors from selling. But in understanding that investors will often have interests that diverge from those of the business itself, one can see that it does make sense – sometimes – to vest enough authority in managers to let them ignore their shareholders and keep plugging away for the long-term benefit of the franchise.

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I’m offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company’s earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you’ll get five percent; 15 percent gets you 15 percent; 30 percent…whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It’s all legit in this little magical mystery market of mine.

So, let your mind wander. If you’re freed from the constraints of price…if you get to pick any company you want that trades in the public markets…let your brain get excited and greedy over the exercise, and decide…what five companies would you pick?

The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely…

1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it’s not losing business to the competition) and/or margins (competitors aren’t finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can’t buy companies that grow in unprofitable ways…though I doubt many of these could last ten years.)

What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I’ll keep a running update on the blog.

Sincerely,

Paul

You can email me at pauldryden (at) gmail.

***

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

– Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

 

All eyes are on Facebook and CEO Mark Zuckerberg as the stock is scheduled to debut on the NYSE this Friday. They have lips flapping as pundits and gurus are shouting over each other to get their opinions noted on whether this business is worth your investment dollars. Allow me to add to the din by expanding on my previous post, Whom Does Management Serve?

Zuckerberg has garnered plenty of criticism for pocketing the majority of voting rights, ensuring that he will have total and complete control over every aspect of the business, not the least of which is strategic direction. And he’s not shy about saying has his own plans for the company which is likely to be at odds frequently with investors looking for financial results.

Facebook’s Registration Statement (filed in February with the SEC) contains a letter from Zuckerberg outlining his priorities. Some excerpts…

 

Facebook was not originally founded to be a company. We’ve always cared primarily about our social mission, the services we’re building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works…

Simply put: we don’t build services to make money; we make money to build better services. And we think this is a good way to build something…

These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.

By focusing on our mission and building great services, we believe we will create the most value for our shareholders and partners over the long term — and this in turn will enable us to keep attracting the best people and building more great services.

We don’t wake up in the morning with the primary goal of making money, but we understand that the best way to achieve our mission is to build a strong and valuable company. This is how we think about our IPO as well.

Here we have a CEO telling the world, in no uncertain terms, that maximizing profits is not his priority. He has a bigger and different vision for the world. As investors we should be aghast, right?

Before addressing that, let me admit that I have no idea what Facebook is worth as a business. It’s probably a fair amount, but my prevailing model used to understand social media companies is MySpace.  It was the pre-Facebook darling, beneficiary of young eyeballs and the power of the network effect. As such, it was scooped up by News Corp for a fat price. And shortly thereafter all the eyeballs left. Quickly and unceremoniously. That fickle bunch decided Facebook was the place to do all the stuff they had previously done on MySpace. And now MySpace is a shadow of its former self.

We’re assured that Facebook is superior, having solved all the problems that plagued MySpace and left subscribers willing to entertain an alternative. That would never happen to Facebook, we’re assured. Maybe. But I’m not comfortable with the possibility, and so it’s a clear pass for me.

That being said, I’ll confess the utmost admiration for the move Zuckerberg pulled to consolidate control. And if Facebook is going to live up to its potential, it will come at the hands of the founder. He has a vision for it that extends beyond share price. I think that’s essential for a business. They lose their soul when they get too eager to please shareholders.

If I could get pass the MySpace hang up, I would assess the following in determining if Facebook was a good investment…

First, is it participating in a large and/or growing market for the services it offers? I believe it probably is. It has a lot of room to add new users and expand the ways members utilize it today.

Second, does it have a profitable economic model? (i.e., Do its revenues exceeds its costs and expenses and can it produce earnings in excess of its costs of reinvested capital?) Most likely, yes. It’s profitable now, though throwing tons of cash back into growth. That user base must have some economic value, and the management minds at Facebook will likely discover the right method for tapping into it.

Third, does it have competitive advantages in place that protect its market share and margins from encroachment? That’s the part that I just don’t know, and I don’t think I could wrap my head around that issue even if I decided to spend a lot of time researching it.

If the answers to these questions were yes, and I believed Mark Zuckerberg had the ability to drive its success by focusing on the long-term value of Facebook as it serves as social connector for the world…but that in continuing to build it in that model, he was likely to face the ire of investors that would prefer profits now rather than wait…

Then I would celebrate Zuckerberg cornering control the way that he did. As a long-term investor, I would celebrate a CEO that openly denigrates profit decisions in favor of investing in the long-term competitive advantages of the business. And I would relish the fact that profit-takers would have no voice in the decisions guiding the business.

I would appreciate that the characteristics that make Facebook a franchise will be stronger five or ten years hence, and that I would therefore own a piece of a much more valuable pie.

But there are a lot of “ifs” to be satisfied first.

Part of my screening process is seeking out companies whose investors have become captive to the Shleifer Effect, overreacting to ostensibly bad news to drive the stock price down. I use “ostensibly” because I’m looking for instances in which:

A.) Interpretation Arbitrage

(Forgive my feeble attempts at coining a new phrase. I won’t promise it will stick. I’ll probably forget about it myself.)

Investors have interpreted declining earnings – and the resulting earnings misses – as bad news and reacted accordingly by changing their opinions on the firm’s future and selling off shares. They’ve misinterpreted the financial information or news, creating an “interpretation arbitrage” opportunity.

Sometimes the EPS miss does not represent a change in the company’s prospects. It can be random. It can be part of the grittiness of operating a business where you’re just going to have down periods from time to time. Or (my favorite) it can be the result of management investing heavily in their advantages or best growth opportunities, driving up expenses faster than revenue can follow.

Or,

B.) Time Arbitrage

Investors have witnessed declining earnings, correctly interpreted the results as temporary, but determined other investors will likely sell-off as a result, decided their own investing timeline is not long enough to wait it out, and so sell their holdings.

The business will be fine, and these owners have probably reached that same conclusion. But they must please their own investors this week, month, quarter, or year. The bad news might lead to several quarters or even a few years of depressed prices. The time arbitrage opportunity exists for anyone with the stomach and holding horizon to stick it out for the long-term gains.

*****

Enter Thomson Reuters (TRI), the information and business news giant. By way of background, Thomson acquired Reuters in 2007 for a whopping $16 billion. This for $600 million in operating income, indicating this wasn’t a merger made primarily for earnings considerations. This was a strategic move to combine content offerings in an attempt to create a more perfect set of products. It was designed for synergy, and it was intended to create a viable competitor for Bloomberg, L.P. in the lucrative markets for trading desk data and information.

Investors greeted the strategy warmly despite the price tag. Thomson traded in a $40 to $50 range for some time. It collapsed to $20 per share in late-2008, and understandably so given the uncertainty surrounding financial institutions, a group that represented the lion’s share of its customer base. It recovered back to the low-40s by early-2011, but has since been on a long slide to mid-20s.

At this writing TRI trades at 28.50, creating a market cap of $23.6 billion on trailing earnings (excluding a huge non-cash write-off of $3 billion) of about $2.3 billion. That’s 10x semi-normalized net earnings, which looks pretty cheap. Of course the company has been reinvesting upwards of $1 billion each year in capex, suggesting (in the roughest of calculations) that owner earnings are probably more like $1.3 billion.

Despite plenty of ups and downs, the stock price has not generated wealth for its investors since the acquisition. Indeed, long-term owners (in particular, the Thomson family which owns about 55 percent of the business) are suffering.

The stagnant price, in and of itself, could be enough to indicate an investment opportunity. The Thomson Reuter combination story is clearly out of favor with Wall Street. But more interesting to me is the heavy investment the company has been plowing into a product it calls Eikon.

 

*****

Eikon is meant to be the culmination of the synergies between Thomson and Reuters…the ultimate justification for the expensive merger. (Take a look at the terminal/service here.)

Joanna Pachner of Canadian Business put together an excellent overview of TRI’s great hopes for Eikon in a February 2012 piece here. She writes:

 

The Eikon platform, which cost a billion dollars and took more than two years to build, gave users access to the two companies’ combined intelligence on one desktop—hundreds of news sources, research reports and analytical and trading tools that brokers, bankers and analysts rely on to weigh investments, assess risk and conduct transactions.

There’s no question that TRI has leaned heavily into this investment. Both sales and earnings have suffered as a result. This has all the hallmarks of a Shleifer Effect opportunity. While revenue has grown year over year, reported earnings have declined each year since 2008. This creates a narrative for Wall Street of a business in a holding pattern (at best) or whose offerings are in decline (at worst).  As the Shleifer Effect describes, investors tend to see patterns in the earnings. Unless they have strong reason to believe otherwise, they interpret a down-sloped trend line to keep the same trajectory in the future. Owners sell. New buyers are loathe to come in. The long-suffering of shareholders tends to chase away all but the most entrenched interests.

The great hopes for Eikon and the stability of the Thomson family 55 percent stake in the business have probably mitigated the effect somewhat.

Eikon holds out a double-sided promise to expand operating margins from 18 percent to mid-20s. On the revenue side, it is meant to drive TRI into new markets with new clients. It’s supposed to be so cutting edge and so easy to use, it will cast a halo on the company and the rest of its products, easing the growth path into new geographic markets and adjacent line expansions.

On the expense side, it allows TRI to cut 200 expensive legacy systems with their equipment costs, maintenance, and separate silos for sales, customer service, etc. In its 2011 investor day presentation, TRI anticipates Eikon allowing it to consolidate from 172 data centers to six, from 19 delivery infrastructures to one, and from 1,600 developers to only 1,000.

 

The ambitions are large. Each percentage improvement in operating margin is $130 million-plus increase in earnings. If TRI can accomplish its goals – successfully launch Eikon, realize the strategy behind the Reuters acquisition five years ago – the business should be much more valuable than Mr. Market gives it credit today.

Eikon creates a binary decision-making process on TRI as an investment. If Eikon succeeds, TRI will look cheap a few years out. But if Eikon fails, the Mr. Market has probably been too generous with his 18x market cap to owner earnings multiple.

*****

Strategies that look so good in investor presentations, and whose numbers hold such great promise for enriching shareholders, are not implemented in a vacuum. No, companies must execute them in the live-fire world of resource constraints, operational hurdles, and constant competitive challenges.

In a previous life I was part of a software company that sat on a cash-cow of legacy products used by a couple hundred hospitals nationwide. The products were solid, but the limitations of the old technology meant there was little we could do to expand their functionality. And (even worse) the legacy platform was becoming passe. No one was buying the operating system anymore. We had a decision to make…milk the cow until it ran dry, or try to reinvent the business.

Given the ambitious management team, we chose the latter path. (The ambitious are prone to action even in the face of difficulty and often despite odds stacked wildly against them.) We transitioned to a new platform. First we called it ASP, then SaaS, now cloud-computing. Using the legacy features as our blueprint, we built several new products from scratch. They were a thing to behold! The latest. The greatest. We expected the market to beat a path to our door, demanding the products immediately and waving crisp dollar bills under our noses.

That didn’t happen.

Well, at least we had our fallback. We would offer our existing legacy customers the opportunity to transition to the new products, revel in their benefits, and spout the benefits to the rest of the world. Well, they didn’t want to change.

We were stuck. We went through a couple rounds of lay-offs. And then the president went for the hail-mary. He sunset the legacy products, announcing to the customers that they had 18 months to transition to the new platform before we stopped supporting the old. The gamble paid-off. Mostly. With much grumbling and gnashing of teeth (we heard the term “extortion” over and over again), we managed to swap over a little better than half of existing customers. We survived the loss of clients because we forced them to pay a premium for the new products.

What happened to the others? This is the most informative part of the story when thinking about introducing new technology products…while they would have continued paying us for years on the legacy products (inertia is a powerful force when dealing with IT buyers), when we forced them to make a decision they decided to open up their process to our competitors. And our competitors got fat and happy off the defections.

Lesson for all…heavy investments in technology upgrades are painful for everyone involved. Even if you think you’re loved by your customers, pushing an upgrade (that requires new equipment, new training…just change in general, even if there is no additional cost) creates opportunity for your competition. In the enterprise software business, the long knives come out when a foe is pushing an upgrade or transitioning to new platforms. From a sales and marketing perspective, you know you can ramp up your prospecting when there is an opportunity to drive a wedge between a previously unbreakable bond between client and vendor.

Such is the reality that Thomson Reuters has faced with attempting to funnel hundreds of legacy applications into a single platform. One, there is the normal intransigence from existing clients around IT changes. And two, change gives those clients an opportunity to get cozy with the competition.

*****

As measured by nearly all significant metrics, the Eikon launch has been a dud. This despite a two-year development effort, involving the work of some 2,000 programmers, a reported 1,000 client beta test, and a heavy marketing push through major financial media.

The results? According to the Canadian Business article, nine months into the launch only 25,000 of TRI’s 400,000 financial product users have transitioned to the new platform. Worst yet, only 3,500 new users have signed up. The CEO of the Eikon division left the company with several of his lieutenants. The company CEO, Tom Glocer, took over. Soon enough, he was shown the door.

According to this FT.com article from July 2011…

 

…deployment of the platform has been marred by poor product integration, cumbersome technology, and a fragmented sales effort. One industry executive familiar with the company said that where co-operation over the implementation of Eikon had been required, there had instead been “territoriality”.

 The Economist supplies this graph, comparing the market share of Thomson Reuters financial offerings versus those of Bloomberg. At the merger, TRI had a distinct advantage. But Bloomberg has closed that share at an astonishing rate. Indeed, Bloomberg defines the competitive environment into which Eikon is attempting its launch.

 

 

What has Bloomberg done during the Eikon launch? A lot. This is, I think, the most damning evidence against the long-term potential of Eikon competing against Bloomberg.

Computer World UK reported in February 2012 that Bloomberg dived into its own platform redesign…Bloomberg NEXT. The results versus TRI’s attempt could hardly diverge more. Bloomberg spent a reported $100 million versus TRI’s $1 billion. It programmers worked extensively with end-users, making sure to track their acceptance of changes and new features. It was an Apple-like design approach. Bloomberg moved some 100,000 of its 300,000 customers in the first few month and said it expected to move the rest by end of 2012.

And Bloomberg isn’t stopping there. Sensing a weakened opponent, it’s pushing its advantage by going even deeper into markets that TRI has traditionally dominated. From the Canadian Business article:

 

This month, Bloomberg launched another salvo across TR’s bow by unveiling a new tool that will let clients freely access information for which TR charges fees. The private company has said it expects its fiscal 2011 revenue to rise 11%, to $7.6 billion—a much steeper growth curve than the 2% Burton-Taylor projects for the industry. The two companies’ market-share trajectories sum up the momentum: both now have around 31%, but for Bloomberg, that’s up from 25% in 2005; TR is down from 37%.

I’ll use two more quotes and then end this comparison between rivals. First, Bloomberg executives are displaying thinly veiled schadenfreude at TRI’s troubles. Regarding NEXT, Tom Secunda (Bloomberg co-founder) states:

 

Simplicity has tremendous value. A function that’s brilliant and never used is worth zero…Our business model is that we keep our price fixed but we dramatically increase the value of our product. 

Second, the Candadian Business article winds up using this conclusion (apt, I think):

 

TR executives may be confronting a disheartening realization: that even a huge investment in state-of-the-art technology, which is in many ways superior to its main competition, may not be enough to reverse its slide and Bloomberg’s gains—“which goes to the core of how entrenched Bloomberg is,” says Aspesi. TR admitted last year, he says, that it doesn’t expect to regain the market share it’s lost any time soon. In what promises to be a very tough year in the financial markets, amid economic weakness and European instability, Thomson Reuters may have to significantly change its game plan. “The merger could not have made more sense,” sums up Taylor. “The strategy is still sound. But the tactical implementation just hasn’t worked.”

*****

Using screens to identify investment candidates, Thomson Reuters showed some early promise. While somewhat cheap on a reported earnings basis, the company was clearly investing heavily in what it saw as a future franchise…Eikon. It just might be a Shleifer Effect interpretation arbitrage opportunity. For purpose of our assessment, the success or failure of Eikon really is the driver, creating a decision based on a very simplified question…

Do we have good reason to believe that Eikon will succeed, creating stronger earnings in the future, and protecting the business with a competitive advantage against the likes of Bloomberg?

From the evidence we collected, it seems the answer is “no.” Reality might very well play out differently. Perhaps there’s something going on behind the scenes that we just don’t understand. Perhaps TRI is worth considerably more after another year or two of getting Eikon (and its other businesses) right. I’ll accept that possibility while understanding that I don’t see a clear, conservative path to it. The shallow competence I possess calls TRI a pass.

One of my college professors revered Abraham Lincoln, seeing him not only as a remarkable leader but also placing him among the pantheon of great political thinkers.  As such, this professor enjoyed sharing anecdotes and insights gleaned from the life of Lincoln.

I recall one insight in particular.

Aesop’s Fables was one of the few books to which Lincoln had access as a child. And so he read it assiduously for years, memorizing his favorite tales and ruminating on the meaning of each. According to my professor, the stories shaped Lincoln as he carried the morals with him throughout life. But perhaps more importantly, Lincoln internalized the practice of narrow-yet-deep reading in which he allowed his mind to fumble through the many layers of nuance in what he read, struggling with the material in an effort to internalize its lessons and understand it at the deepest level.

The professor urged us to develop the same skills, assigning us the task of writing papers on the briefest excerpts from Plato, Thucydides, or Montesquieu. We were not allowed to go to other sources for hints at what the philosophers might have meant. Our job was to struggle with the original text, fumble through the possibilities, and dig deep to explain its meaning in our own words.

This was torture! My skill – refined by much practice – was making a cursory run through the material, pulling in quotable commentary from published scholars, flowering my prose with SAT vocabulary words, and punching the essay home with a nice summary. I became quite good at writing long papers with very little actual thinking required.

I still struggle with going deep. My attention span still prefers wide-and-narrow reading versus Lincoln’s narrow-yet-deep approach. But every once in a while I’m pulled back to learn and re-learn from old pieces. So, without further ado, here’s the segue…

*****

Buffett Defines Owner Earnings (1986)

If ever there were a single piece of valuation wisdom worth revisiting again and again to internalize its lessons, it just might come from Warren Buffett’s 1986 Letter to Shareholders in which he outlines the case for owner earnings versus those required by GAAP reporting. Berkshire Hathaway’s purchase of Scott Fetzer provides the example. (Scroll to the appendix, entitled Purchase-Price Accounting Adjustments and the “Cash Flow” Fallacy.)

Buffett writes:

If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c).

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”

…Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists – that is, when (c) exceeds (b) – GAAP earnings overstate owner earnings. Frequently this overstatement is substantial…

“cash flow” is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment – or the business decays.

When one first reads this passage, one is tempted by the variables. One is eager to plug them into a simple formula, the values for which one might pull straight from an accounting statement. One hopes the quick calculation yields the secret of the true value of the business.

Owner Earnings = (A) Reported Earnings + (B) Various Non-Cash Charges – (C) Capex and Working Capital Necessary to Retain Current Competitive Position 

(A) and (B) give one much hope. But alas, (C) is confounding. It requires tremendous knowledge of the business and the economics of the industry to come up with even a reasonable guess of that value. Even managers of the company can be very wrong when trying to determine what portion of the earnings must go back into the assets or working capital just to keep the business from losing ground.

Owner earnings are those that are available to be plowed back into the business in order to create even more earnings in the future (capital investments, investment in expense infrastructure, or acquisitions) or paid-out (dividends, share buybacks, debt repayment) to shareholders.  They are the only portion of earnings that provide economic value to owners! If you owned the business outright, they are the portion you can strip from the business for different purposes while remaining confident you have left enough that it keeps laying golden eggs for you year after year. 

In his 1984 letter, Buffett calls these unrestricted earnings. In essence, the managers can use their discretion when deciding how to use this money without fear of injuring the competitive position of the business.

By way of contrast, restricted earnings – which are the same as (C) and which Buffett calls ersatz* – cannot be pulled out of the business without causing damage. (It’s like running to stand still. By continuing to reinvest the restricted earnings, the prize is standing your ground…not ceding market share to your competitors; keeping earnings at the same level as today. But if you don’t reinvest, your business decays over time.)

The trick, for managers and investors alike, is figuring out what portion of capital expense and/or increased expense structure is needed to maintain the current earnings versus how much is going toward promoting earnings growth in the future.

*****

Amazon.com In This Context

In a previous post we noted that Amazon.com is being criticized that its torrid pace of revenue growth has not been matched by proportional earnings growth…at least not over the past few quarters. Its expenses are soaring as it leans into its growth and into shoring up its competitive position in key markets.

This is the question I want to explore…

Is Amazon increasing its spending – and thereby reducing its profits today – because

1.) It has no choice and is acting out of defense to preserve the current stream of earnings? In other words, Amazon has increased its spending in order to hold off competition and maintain market share. If it weren’t investing in price reductions, subsidized shipping, content, engineering talent, etc. competitors would be stealing customers, market share, etc.

Or…

2.) By design, it is on the offensive? It’s making investments in gaining market share or otherwise strengthening its competitive position with the objective of expanding earnings in the future?

We’ll consider those questions next.

*Ersatz Earnings…Restricted vs. Unrestricted (Buffett’s 1984 Letter)

…allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.

The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios – inflation causes some or all of the reported earnings to become ersatz. The ersatz portion – let’s call these earnings “restricted” – cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential…

…Let’s turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.

This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders – to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.

 

Tom Russo of Gardner, Russo & Gardner delivered an insightful speech at the 2011 Value Investor Conference in Omaha. While thinking about Amazon.com and its heavy reinvestment in the company’s expense infrastructure, I revisited portions of the presentation. I’ll draw heavily from it below. (You can access the full speech in pdf format here.)

*****

It’s Hard to Make a Dollar Bill Grow…You Need the Capacity to Suffer

It’s hard to make that dollar bill grow, that’s the problem. And in public companies typically it’s the case that managements are not prepared to invest as fully as they could in pursuit of the growth of the dollar bill…So what I’ve looked for are businesses that for one reason or another are willing to invest hard behind their growth. And what that means is they have the capacity to suffer. 

When you invest money to extend a business into new geographies or adjacent brands or into other areas, you typically don’t get an early return on this. And this is a very important lesson. 

Most public company managers worry about…[what]…they may encounter…if they invest heavily behind a new project, they may show numbers that are unattractive and they worry about the loss of corporate control. 

Suffer Through Reinvestment Case Study One: GEICO and Net Present Value of Adding New Policy Holders

He [Buffett] told management at GEICO just to grow the business even though each new policy holder that was put on the books cost an enormous amount of losses the first year. They had high net present values and you’ve seen the history. I think the number insured at GEICO, because of Berkshire’s willingness  to show the losses up front, have grown from just under a million policy holders to almost ten million. And his spending to drive that growth that just burdens operating income up front has grown from $30 million a year to almost $900 million….

…But the fact is by spending up front, having the elasticity, the willingness, to burden your income statement and then getting the results in the future is a very nice trade off. 

 Suffer Through Reinvestment Case Study Two: Starbucks in China

One of the examples that comes to mind…is Charles Schultz, the chairman of Starbucks, who several years back spoke to investors, and there was one nettlesome young analyst who kept asking the head of Starbucks when they would show profits in China. 

And the dialog went back and forth: When will you show profits? He said, how big do you want us to be? When will you show profits? How big do you want us to be? And it went back and forth like this. 

And the answer was – and I think it’s the true one – if you want us to dominate China, then let us not show profits for a long time. And if you permit that, we will end up at the final analysis with a dominant position in an important market with moat-like characteristics. If you try to establish, as so many American companies did, a base in China and do it without impacting earnings, you’ll do it with a very small business that won’t have a competitive franchise. 

And that trade off is just as clear an expression of this notion of the capacity to suffer. Now Schultz  isn’t going to lose Starbucks because he has enough stock to keep it on the course that he chooses. But there are many companies that don’t have that control. Most don’t. And so they favor short-term results versus the long term. 


*****

Capacity to suffer. I like that. To Russo’s point, there is a common thread that unites his GEICO and Starbucks examples, a thread which can extend to our evaluation of Amazon. That is, an ownership structure that keeps investors at bay because someone (or some entity) has enough control to keep to a strategic path that offers long-term benefit despite short-term suffering…trading the opportunity to build a franchise for less profit (or losses) today.

With somewhere around 20 percent of Amazon shares under his control, CEO Jeff Bezos remains firmly in control of business strategy and is willing to forego instant gratification as he builds a franchise for the long haul. He is hailed as a genius when revenues grow but panned by the financial media when there are signs of slowing down. All the while, the dude abides. He stays the course of his longer term vision for the franchise.

It would be easy enough to straddle the fence between investing for the future and satisfying the call for ever improving profits. It’s called earnings management. Most managers of guilty of it to varying degrees.

Though I’ve never sat anywhere near the catbird’s seat in a publicly traded company, I can imagine the temptation to do this is profound…that there’s always a nagging itch from employees with options, shareholders, your own net worth measurements to make a little compromise here, hold back on some needed investment there…to feed the earnings machine, pacify Wall Street, and prop up the stock price. Just scratch the itch a little bit. It will feel so much better.

But once you scratch it, does the itch actually ever go away? Doubtful. You end up getting caught up in the endless game of analyst expectations. By bowing to it, you become complicit, and it’s hard to tap out.

I expect plenty of managers have a strong sense of where they can invest their dollars to fortify their competitive advantages, expand their moats, and grow their franchise. But they are too invested in the earnings management game to take the short-term hit that’s likely to follow.  Or they know it could threaten their tenuous hold over strategic control. Or they suspect they would lose their job if Wall Street says results are in decline. Even if they had the intestinal fortitude to suffer through the tempest, their job could be pulled from them before they had the chance to show that ability.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. 

– Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter

The following exchange took place during the Q&A portion of the 2011 Berkshire-Hathaway Annual Meeting. It is paraphrased from this account provided by Ben Claremon of The Inoculated Investor blog.

QuestionThe only option for a shareholder nearing retirement to get income is to sell shares of Berkshire-Hathaway stock. This is because the company doesn’t pay a dividend, even though you like to collect dividends. So, when would you consider paying a dividend?

Warren BuffettCharlie and I will pay a dividend when we have lost the ability to invest a dollar in a way that creates more than a dollar in present value for the shareholders…Every dollar that has stayed with Berkshire has grown much more than it would have if it had been paid out as a dividend. As such, it is much more intelligent to leave a dollar in…There will come a time – and it may come soon – when we can’t lay out $15 billion a year and get back something that is worth more than that for shareholders. The stock will go down that day. And it should because paying a dividend means the compounding machine is dead.

*****

Like all businesses, Amazon has decisions to make about what it does with its cash. There really are only a handful of choices: pay it out to investors (dividends, share buybacks, and debt pay-off), plow it back into the business (capital investment, expense investment, and acquisitions), or let the cash accumulate.

If Amazon management has good reason to believe that plow-back investments are likely to produce greater earnings power in the future – and by that I mean the returns on the investment are in excess of the cost of the capital, or what a reasonable investor might expect to earn on the cash if he were to deploy it outside of Amazon – then they should reinvest in the business. If they believe that the plow-backs will allow them to create a franchise with enduring competitive advantages, I would go so far as saying they have a fiduciary responsibility to continue reinvesting in the business.

Many value investors like companies that are quick to return cash to shareholders. I understand that. There’s security to getting that cash out. It creates warm and fuzzy feelings, and it lets you deploy it for other purposes like consumption (that new iPad or the bracelet your wife wants) or alternative investments. 

Theoretically speaking, when businesses return cash to shareholders they’re confessing to one of two things. 

One, that they can grow earnings without reinvesting more cash. They simply don’t need the cash. These businesses are gems and equally as rare (or at least too pricey for value-minded investors to consider).

Two, that they cannot reinvest that cash in a way that produces satisfactory returns. They are running out of profitable growth opportunities. And in that case, returning cash to investors is the responsible thing to do. 

(I write “theoretically” at the outset because oftentimes managers return cash to shareholders irrespective of reinvestment opportunity because they have a history of paying out dividends and any change to that history will cause much consternation in the shareholder base. They don’t want the stigma of being the managers who cut the dividend, ticked off legacy investors, created concerns – legitimate or not – about the business health, and caused a dip in the stock price.)

When we wish for the security of dividends, it usually means we’re wishing the companies we have invested in have run out of markets for profitable reinvestment. It means we don’t want them to grow as much as perhaps they could. It means we’re welcoming the day the compounding machine died.

Should current owners of Amazon wish the company stopped its investments in…

  • subsidized shipping to pull more shoppers to the web and away from traditional retail?
  • lower prices on products and services to entice more consumers into utilizing Amazon and becoming repeat customers? 
  • content to encourage more customer loyalty via Amazon Prime membership?
  • increased fulfillment capacity in warehouses whose proximity guarantee faster delivery of an even wider selection of products?
  • software that makes buying easier, faster, and more secure?
  • devices like Kindles which encourage consumption of high margin digital media as well as increased shopping on Amazon.com?
  • technical talent to extend market dominance over the burgeoning field of cloud computing?
  • more server and hardware infrastructure to attract more cloud computing customers?
  • little (expensive!) orange robots that will drastically reduce the company’s dependence on (expensive!) manpower (and air conditioning) over time?

In business, as in life, there are always trade offs. If we want Amazon to show us more earnings now, or to share the cash with us, we must be willing to give up the long-term advantages created for the business by making the investments listed above. We must trade future earnings for immediate cash.

The question becomes…how much do the investments above enhance the value of the business by allowing it to generate greater earnings in the future?

Quick answer: I don’t know…but it’s still worth thinking through some possible scenarios.