Unpredictable Businesses and Their Perils

 Unpredictable Businesses and Their Perils

The process of moving away from an operation is sometimes more drawn out than what an impartial observer would have anticipated, especially if a significant amount of money, people, and pride are involved.

From a distance, it is easy for an investor to perceive a company through the eyes of a rational capital allocator. On the other hand, few individuals in the company possess the ability to see that far into the future. 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. Moreover, these issues preoccupy the minds of the managers on a daily basis. When a company continues to flounder, it's usually not because of a single catastrophic error but rather a chain reaction of smaller ones that add up to the demise of the enterprise.

The tremendous relevance of a company's inflexibility as it pertains to a specific industry, production method, or workforce is hard to recognize. 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. It's comforting to believe that managers will recognize the clear threat, take action to fix it, and transform the organization permanently before the inevitable happens. However, a leap of faith is necessary for that type of thinking. The investor has a tendency to accept his own delusions and think that tomorrow would somehow sort itself out.

Despite his vigilance in avoiding long-term investments in companies with weak economics, Warren Buffett, too, has fallen victim to illusions of a smooth transition. From Buffett's career, we can probably pick out three instances where he displayed such fantasies. It is adequate to discuss just two; Hochschild-Kohn, a department store in Baltimore, would make up the third.

Late in 1993, Buffett had his most recent illusion. Around that time, Berkshire Hathaway bought out Dexter Shoe. It was a mistake, Buffett now knows. He penned the following in his 2001 annual letter to participants:

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.Prior to our takeover, and even for a few years afterward, Dexter thrived in the face of extremely aggressive, low-priced competition from overseas. I was mistaken in thinking Dexter could keep dealing with the issue.

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 misleading assumption underpinned his purchase. It wasn't as simple as paying too much (with shares). His final choice, "procrastinating when the need for changes in its operations was obvious," is worth noting as well. It's not easy to admit that.

Procrastination is a decision, according to Buffett. It was undoubtedly an expensive decision, but it was also one that had to be made every day, rather than just once between two options. Many people in business make the mistake of thinking that doing nothing is worse than doing something wrong. However, this is a very ineffective strategy for improving one's performance. In the investment world in particular, inaction deserves the same severe scrutiny as action.

What makes this whole thing intriguing is how Buffett decouples his inaction in demanding reform at Dexter Shoe from the purchase itself. He makes no indication that it would have been a good idea to purchase the company and then attempt to make changes to it. If Buffett is to be believed, skipping the acquisition of the company altogether would have been the wisest move.

I agree with him. It is tough to put a price on the dangers associated with buying a rigid company. Having said that, they do exist. When these dangers are substantial enough, they can wipe out any bargain-basement value that derives from strong present earnings (or cash flow).

An investment in a company based on its potential cash flow is a surefire recipe for financial disaster. Frequently, the purchaser is fully cognizant of this potentiality. But he persuades himself that the change will happen quickly enough, thanks to his logical analysis of the facts and his drive to maximize the return on investment.

Having such a clear perspective is unusual for operating managers. The will is frequently absent even when the way ahead is obvious. Decisions that appear to provide a medium ground are easy to rationalize. An enticing possibility is always a slow shift. Defining a retreat as a fighting withdrawal sounds like something anyone would want to do.

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

"(1) When it comes to our textile businesses, they play a significant role in their communities as employers. (2) When issues arise, management is honest about them and takes action. (3) Workers are helpful and understanding when dealing with our shared problems. (4) In terms of cash returns relative to investment, the business should be modest."

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. Gains in the future that seem possible due to increased industry efficiency and better circumstances almost never materialize, as history shows. Hope was ever present. However, 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. There appeared to be a clear victor among the many suggestions to do so. When we compared these plans to our very lucrative candy and newspaper companies, we found that the economic benefits promised by these ideas were often higher, according to traditional return-on-investment tests.The gains that were supposed to come from these textile investments, however, never materialized.

The arguments put up in favor of these investments were flawed, as any impartial observer would have noticed. There was an excess of capacity, which severely impacted the sector. There was a horrific capital misallocation in the past that squandered a large influx of funds into an apparently promising industry.

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. A factory that doesn't crank out any goods is worse than useless. A money pit, that is. The sole options for the owner are to either leave the company or do everything it takes to get the best variable costs. Everyone will be bored if enough people choose option (b).

Several of our local and international rivals were also making similar investments, and when a sufficient number of businesses did so, 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 canceling 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 anemic.

For investors, it's helpful to picture a group of people watching a parade on tiptoe. This is the hallmark of a poorly run company. Investing like this is something you should stay away from. It is unusual for a corporation to leave a company on favorable financial terms. This happens gradually, after the apparent inexorable fall has been going on for some time.

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. Examples from more recent times include Xerox and Kodak (EK). The workforce of General Motors (GM) is rooted in a different time. An example of a rigid company is General Motors, which is firmly attached to both its industry and its specific place within it. 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.

Such changes can have devastating effects. The bright side is that businesses that could be vulnerable to these potential dangers can be easily identified. Huge and unionized, General Motors was an enterprise. Its proportion of the American market was enormous. Its market share had to be preserved, of course. Because the thought of General Motors losing market share could have appeared ludicrous to investors a few decades ago, that might not have been on their minds. But if they had given it any thought, they would have realized that keeping a sizable portion of the American market was crucial to GM's existence.

Similarly, if Intel (INTC) or Microsoft (MSFT) saw a significant decline in market share, they would be compelled to swiftly implement massive reforms. 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. Meanwhile, rational investors don't put their money into such companies like Intel or Microsoft unless they think they can keep their product market share about the same.

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. Companies use little armies as a matter of fact. Actually, there are more people working for these two firms than there are American soldiers 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.

It is easy to place too much trust in management, as I have learnt, therefore the "will not" element is crucial. Tough decisions are hated by everyone. A problem's apparentness is no guarantee that individuals who are aware of it will work to resolve it. Many lawmakers in Congress are aware that the national debt is an issue, I'm sure of it. Their realization that fixing the issue will be counterproductive is something I also fully expect. They hope that another person will take up the matter later on. 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. Also, nobody may have made the deliberate decision to keep going in that direction. On the other hand, that's usually exactly what occurs. By the time the owners realize they need to fix the issue, it will be too late. The monetary and time costs are already too high.

Searching for companies where managers won't have to make unpleasant decisions might be a good idea. Regardless of the fundamentals, an investment predicated on the expectation that managers will make tough decisions is inherently risky.

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