Over the weekend, The New York Times ran an article “For Private Equity, a Very Public Disaster” which gave a sobering account of the acquisition of Chysler by the private equity firm Cerberus. There are many lessons in what happened that are worthy of reflection. As anyone who has built up some assets knows, earning money is difficult. Assets, along with reputations, are built over a lifetime, but can be lost or damaged in a very short period. Everyone who invests will make mistakes, but a lot more progress can be made if you simply avoid severe drawdowns to your portfolio. Successful investors think about risk first and study financial history to learn from it. In investing, the allure of massive gains makes turnarounds very attractive. The problem is that few of them actually turn. Here are some thoughts from this “very public disaster”.
Walk away from deals that are “too hard”. “Maybe what we should have done was not bought it.” – Steve Feinberg, a co-founder of Cerberus. The beauty of investing is that you do not have to invest. “I call investing the greatest business in the world,” Buffett says, “because you never have to swing.” You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”
Avoid the “institutional imperative”. Thomas Brown defines what Buffett calls the institutional imperative as, “Any company’s inherent propensity to do dumb things (or avoid doing smart things) simply for the sake of doing them.” Plumbers plumb; painters paint, private equity firms do deals (sometimes that simply should not be done). The allure of transforming an American icon and bringing it back to prosperity may have clouded Fienberg’s judgment. Individual investors would be wise to avoid investing in any company where there is evidence of the institutional imperative, such as a track record of overpaying for value destroying acquisitions.
Good (or even great) management is not enough. The article reports that Feinberg, “Can play a decent game of chess while blindfolded”, and that he is a graduate of Princeton. He is obviously a smart, accomplished businessman and one can safely assume that the Cerberus is loaded with similarly smart and accomplished people. Cerberus’ management contended that, “They had the smarts and managerial prowess to repair companies of any size.” This is usually not enough, however, to overcome a business that is structurally challenged.
Writing to shareholders in 1985, Buffett said, “My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Some years ago I wrote: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”
Avoid excessive debt. The article reports that the, “Situation was made worse by hefty interest payments on more than $10 billion in debt that Cerberus arranged for Chrysler as part of the takeover, which left the automaker carrying piles of debt just as auto sales were about to plummet.” The situation is always made worse by excessive debt and leaves an individual or corporation with no margin of safety for the inevitable downturn. Avoid investments in companies that have excessive debt and pay close attention to when debt is coming due. Jim Rogers charts out all future debt, year by year, so he knows exactly when it is due.
Stay within your circle of competence. The article reports that, “Don Johnson, a former Chrysler employee, says he worked on initial production of the Jeep Liberty at a plant in Toledo, Ohio, in summer 2007, when Cerberus won the right to buy Chrysler from Daimler of Germany…. Mr. Johnson says he was always skeptical about the carmaker’s new owners. “Cerberus did not have a clue about the automotive industry,” he says. “I don’t think anything could have been worse.” If you don’t understand a business, you should not invest. You are simply at too great of a disadvantage because it is impossible to thoroughly analyze the business.
Avoid businesses that need to spend their retained earnings (and more) just to maintain current operations. The automobile industry is characterized by an insatiable appetite for cash simply to maintain the business. There is little or no cash leftover for shareholders and the stocks of these companies usually reflect this reality. Consider the following account of General Motors from the book “Buffettology”:
“Between 1985 and 1994 it [GM] earned in total approximately $17.92 a share and paid out in dividends approximately $20.60 a share. During the same time period the company spent approximately $102.34 on capital improvements. If General Motors’ earnings during this period totaled $17.92 and it paid out as dividends $20.60, where did the extra $2.68 that it paid out in dividends and the $102.34 that it spent on capital improvements come from?
From the beginning of 1985 to the end of 1994, General Motors added approximately $33 billion in debt, which equates to a per share increase in debt of approximately $43.70. The company also issued 132 million additional shares of its common stock. General Motors’ per share book value also dropped $34.92 a share, from $45.99 in 1985 to $11.74 in 1994, as new-car-development costs sucked up retained earnings. What did all this do for increasing shareholders’ wealth? Nothing.
In the beginning of 1985 General Motors stock traded at $40 a share. Ten years later, at the end of 1994, the stock traded at, you guessed it, $40 a share.”
Here is an extended quote taken from the 1985 letter to shareholders regarding Buffett’s experience with investing in capital intensive businesses. It is highly instructive.
Though 1979 was moderately profitable, the business [Berkshire Hathaway’s textile mill] thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue…
I should reemphasize that Ken and Garry have been resourceful, energetic and imaginative in attempting to make our textile operation a success. Trying to achieve sustainable profitability, they reworked product lines, machinery configurations and distribution arrangements. We also made a major acquisition, Waumbec Mills, with the expectation of important synergy (a term widely used in business to explain an acquisition that otherwise makes no sense). But in the end nothing worked and I should be faulted for not quitting sooner. A recent Business Week article stated that 250 textile mills have closed since 1980. Their owners were not privy to any information that was unknown to me; they simply processed it more objectively. I ignored Comte’s advice – “the intellect should be the servant of the heart, but not its slave” – and believed what I preferred to believe.
The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage…
Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.
But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.
Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers. I always thought myself in the position described by Woody Allen in one of his movies: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray we have the wisdom to choose correctly.”
For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.
Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington’s basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.
Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 — on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.
This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson’s horse: “A horse that can count to ten is a remarkable horse – not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.