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.

When you're an investor, it's simple to step back and view a company through the eyes of a logical capital allocator. However, there aren't many individuals in the company who can see so far into the future. They can't look at the situation objectively. We are talking about jobs here. There is the recognition of failure. Not to mention the matter of one's own identity. Moreover, these issues preoccupy the minds of the managers on a daily basis. Being stuck in a failing firm for too long is usually not due to a single big mistake, but rather a chain reaction of small ones that add up and make the inevitable worse.

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. We'd all love it if managers could just detect the looming threat, fix it, and transform the company for the better before it happens. However, a leap of faith is necessary for that type of thinking. Investors have a tendency to believe what they want to believe, like the idea that tomorrow will somehow be taken care of.

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. Throughout his career, Buffett likely shown three instances of similar delusions. 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. Dexter Shoe was bought out by Berkshire Hathaway at that point. It was a mistake, Buffett now knows. He penned the following in his 2001 annual letter to shareholders:

First, I bought Dexter without giving it much thought; second, I used stock to pay for it; and third, I put off making necessary adjustments to its operations even though they were evident to you at the time...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.

Three separate decisions are listed by Buffett. 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. He made a mistake using shares or cash to purchase it.

He bought something that didn't exist. It wasn't as simple as paying too much (with shares). The final choice he mentions, "procrastinating when the need for changes in its operations was obvious," is worth mentioning as well. It's not easy to admit that.

Procrastination is a decision, according to Buffett. Even if it wasn't a one-time decision between two pathways, it was still a costly decision that had to be made every day. 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. Particularly when it comes to investing, idleness deserves the same level of criticism as action.

What makes this whole thing intriguing is how Buffett decouples his inaction in demanding reform at Dexter Shoe from the purchase itself. Buying the company and attempting to make changes would not have been a good idea, according to him. It appears like Buffett is implying that the wisest move would have been to stay out of the business altogether.

I agree with him. Buying an inflexible business comes with risks that are hard to put a price on. Having said that, they do exist. These dangers are usually substantial enough to negate any apparent value that may have arisen from a low asking price in relation to strong present profits (or cash flow).

A company bought for its cash flow potential may turn into a money hole in no time. This is something that the customer is usually fully cognizant of. Nevertheless, he persuades himself that the essential change will be implemented swiftly, as dictated by a reasonable evaluation of the facts and a determination to maximize the use of money.

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 easier to rationalize. There is always the allure of a more gradual shift. Who among us wouldn't want to trick ourselves into thinking a retreat is actually an offensive withdrawal?

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

"(1) The textile businesses play a significant role in their communities as employers. (2) Management has been transparent in reporting issues and has taken proactive measures to address them. (3) Labor has been supportive and understanding in tackling our shared challenges. (4) Relative to investment, the business should generate modest cash returns."

"I was completely mistaken regarding (4)..."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.

Only with respect to his fourth justification for continuing in the textile industry did Buffett succumb to the illusion. The allure of a mediocre firm lies in the expectation of modest returns.

The contrary conclusion would have resulted from a reasonable evaluation of the evidence. Profitability in the future seems possible based on increased efficiency and better industry conditions, but history shows that this is rarely the case. One should never give up hope. Nevertheless, evidence of the validity of such optimism was infrequent.

If we had wanted to lower our variable expenses a little bit, we could have made huge capital investments in the textile industry throughout the years. There appeared to be a clear victor among the many suggestions to do so. According to traditional ROI calculations, these ideas frequently offered more financial gain than we could have gotten from spending the same amount on our very successful candy and newspaper companies.The gains that were supposed to come from these textile investments, however, never materialized.

Those arguing for these investments would have been able to spot the error if they had been impartial. There had too much capacity, which was a problem for 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. It was used for huge expenditures that put a heavy burden on the owners in the form of large fixed costs. There is nothing worse than a factory that doesn't create anything at all. That thing is a money pit. Either the owner walks away from the company or he or she tries to use every trick in the book to get the best possible variable costs. Everyone will be bored if enough people choose option (b).

When a sufficient number of companies made similar investments, their lower costs set the standard for price reductions across the sector. This included both local and international competition. 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. With each new round of investments, everyone's bankroll grew, yet returns were consistently low.

Investors would do well to recall the mental image of a swarm of people watching a parade on tiptoe. This is the hallmark of a poorly run company. You should stay away from this type of investment. 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.

Any company whose operations are rigidly dependent on a single product line, manufacturing process, or employee pool is considered inflexible. Contrary to popular belief, most companies are not directly involved with them.

Just a small number are. Examples from more recent times include Xerox and Kodak (EK). The workforce of General Motors (GM) is rooted in a different time and place. General Motors exemplifies the type of rigid company that is bound not just to a specific sector but also to a specific niche within that sector. The business was not set up to reduce its operations in the case that it lost market share. Even more devastating than technological developments for certain companies is a change in the composition of their target market.

Such changes can have devastating effects. Fortunately, it's not hard to tell which businesses are vulnerable to these potential dangers in the future. Huge and unionized, General Motors was an enterprise. Quite a bit of the American market belonged to it. Keeping its market share was obviously crucial. A few decades ago, investors might not have given that much thought, since the thought of General Motors losing market share might have appeared ludicrous. 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.

In a similar vein, if Microsoft (MSFT) or Intel (INTC) saw a significant decline in their market share, they would need to swiftly implement massive adjustments. A little portion of the market isn't enough to sustain those companies' present structures. Obviously, these companies would have an easier time laying off tens of thousands of workers than GM. However, rational investors do not purchase Intel or Microsoft stock unless they anticipate that these companies will keep their present product market shares.

Both companies are quite concerned about their future market share since the costs they have incurred would be too much for any competitor. Small armies are employed by the firms. The sum of these two corporations' workforces is equal to, if not more than, the number of American troops stationed in Iraq. So, it's obvious that both firms have staked a lot of money on maintaining their dominance. These responsibilities would become unbearable without such control.

Any company you put money into should have some wiggle room. If a big company's revenues drop and their expenses don't fall by the same amount, the business will be in serious trouble.

Because I've seen firsthand how simple it is to trust management blindly, the "will not" component 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. The national debt is an issue, and I think many lawmakers in Congress are aware of it. Furthermore, I am certain that they are aware that fixing the issue would be counterproductive to their goals. They hope that another person will take up the matter later on. Absolutely everyone would.

A thousand little steps can be easily justified. So long as you don't own up to your one major error, you're good to go. Maybe no one ever intends to bind a company to a rigid and possibly dangerous position. For all we know, maybe nobody actively opts to keep going in that direction. However, such is frequently the case. It will be too late for the owners if the situation is left unattended until it becomes critical. The monetary and time costs are already too high.

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

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