This essay is a reflection on an investment mistake and only loosely related to reality.
In memory of Charlie Munger, this fictional “story can best be understood as a classic tragedy in which one flaw is inexorably punished by remorseless Fate”. The flaw was a lack of proper financial management. The tragedy was that this flaw hit an important company with great people and products.
The company’s founder and CEO was highly successful and widely respected, not only for her business wisdom but also life philosophy. She saved the company – and with it the whole industry - from almost certain ruin and, within a few decades, transformed it into the unquestioned global leader, growing sales organically in the mid-single digits and profits at double that rate while avoiding financial debt, creating value for all stakeholders. At times, the company was the biggest employer of her home country, a fact that made her especially proud.
Suppliers appreciated their big and reliable customer who always paid on time and valued win-win relationships. Customers were happy buying the company’s highly engineered and beautiful products. Employees loved to show up for work every day, applying their highly trained skills. The government was thankful for the big tax payment that it received on a yearly basis. And investors were proud to own a company that showed a return on equity well above 10% in almost every single year, despite never paying a dividend. Twice in its long history the company had to endure a financial loss because highly volatile revenues hit on significant operating leverage. But both times the challenges were easily overcome due to the web of deserved trust that the management team has previously built up.
The gradual process of decline started, as it often does, with the choice of successor, in this case the matriarch’s son in law. A highly creative and likeable person, the new CEO decided that basic financial management skills were not for him. He associated the focus on profitability with short-term thinking, entrepreneurship with the purchase of real estate, inventory with economic value and the employment of a maximum number of people as the true purpose of business. Unexpectedly, he also developed a taste for stock options and applied them widely throughout the company. At the beginning of his reign, these characteristics were not fully developed. By constant application over many years and surrounding himself with people that didn’t care to speak up, however, the CEO’s views got more and more entrenched and extreme.
Like his beloved mother-in-law, the CEO showed a taste for provocation, explaining his innovative thinking on several occasions. Unlike his predecessor, however, he also had a disdain for critical thinking. He never took the advice to try to destroy his best loved ideas. On the contrary, he pounded them out, further entrenching them in his own mind. And as the ultimate authority after the death of the matriarch, he made sure that his views were widely accepted within the company, a task made easier by the previously mentioned use of stock options.
At first, outside observers thought of his thinking and talks as a refreshing contrast to prevailing business wisdom. As time went on, however, this benefit of the doubt seemed more and more undeserved. During the first few years of the new CEO’s tenure, rising revenues masked an underlying deterioration of business metrics. Profits rose despite a significant build-up of inventories and property, plant and equipment. The discrepancy between cash flows and accounting profits increased, but doubts were held in check by the phenomenal track record. It was widely believed that, sooner or later, cash flows would catch up to accounting profits. Things only started to come to a head when revenues consistently lagged expectations. Return on equity declined from an average of around 20% during the previous decade to low-single digits for several years in a row.
Smart investors thought of this as a temporary weakness and bought the stock in anticipation of a reversal to the mean. After all, this wasn't the first time in the company's history that revenue growth stalled for several years, even though profitability was unusually depressed. Many observers associated the unlevered balance sheet and correspondingly high equity ratios with business quality. And they were mesmerized by the decade long track record of economic outperformance. However, after holding the stock for multiple years and listening to several of the CEO's rants, even the most well-meaning investors had to realize that they were dealing with a very peculiar phenomenon.
The CEO and his family owned only 5% of the company’s capital, but over 50% of the voting rights, empowering them to press their preferences on to the other shareholders. And those preferences, were,...., unusual. After all, a rational capital allocator could sell the liquid parts of the inventory, lever up the real estate portfolio and, together with the cash on the balance sheet, buy back over half of the company. With the use of a relatively modest amount of leverage, he or she could even take the whole company private. Even though the owner family would have liked this outcome, avoiding the stress of being publicly listed, they valued freedom of debt even more (a rule of thumb that proofed valuable on many occasions in the company's history, but seemed more and more out of line with respect to the important and rapidly growing real estate portfolio). And they didn’t care about financial theories, as many of them were employed inside the company in positions of power and paid themselves millions in salary, making sure that their private financial freedom wasn’t affected by business realities. Undeterred by stagnating revenues, they continued to invest scarce resources in marketing, inventory and expensive properties at negligible incremental returns.
The family owners were in good company, as many of their competitors thought along similar lines, with the slight difference that the latter were privately-held, fully family-owned businesses. The management team also believed in its overoptimistic sales outlook, overestimated its ability to generate future value and engaged in pain-avoiding denial of reality. Compounding these problems, they never changed the dividend policy. When asked by analysts why they decided to do so, the CEO said “because we can”. Overall, leadership showed a disturbing neglect of the economic interests of the vast majority of owners and reduced their communication with them to the legally required minimum.
Management felt that it was fighting a fair fight. Everyone who criticized its line of thinking was attacked as a short-term speculator, or worse. Through the eyes of the CEO, the stock market behaved like a machine for speculation with no relation to fundamental values. The CEO’s recommendation to “sell the stock if you don’t like what you see” was followed by many market participants. But for every seller, there was a buyer, and no matter how often a stock changed hands, only a minority of outside investors was willing to forgo financial returns in favour of ideology and empire building. Investor calls got increasingly tense, at times even heated. The distance between family management and outside shareholders increased by the day.
The immediate result of this sad spectacle was a declining stock price. This was, unfortunately, just the beginning of what turned out to be a much worse ultimate outcome. The company’s balance sheet got bigger and bigger, while the profits in relation to the invested capital became smaller and smaller. The minuscule income from unlevered real estate, the ballooning costs of employee compensation, the lack of market feedback due to inventory build-up and the capital tied up in low-return assets all combined to significantly impair the economic health of the business. Due to high operating leverage, the company had to face the basic asymmetry that even positive revenue surprises didn't suffice to lift profits to a sufficiently high level, while negative surprises (that became more and more the norm) pushed them ever lower. In times of crisis, the company even needed to lay off thousands of people, a fact that truly hurt the CEOs feelings. Never would he have imagined to find himself in such dire circumstances.
When judgment day finally came, the combination of high costs due to structural overemployment, inventory write-downs due to past investments and declining sales proofed near-fatal. The company disappeared into economic irrelevancy with profits and capital returns barely above zero and a market capitalization that didn't increase for well over a decade. The amount of cash that was paid out in dividends during the lifetime of the company turned out to be zero. Contrary to shareholders, however, the owner family was able to take hundreds of millions of currency out of the company by other means. In the end, their privately accumulated capital (that was invested in broadly diversified stock market indices for a return of around 10% per annum, far outpacing the stock market return of their own company) almost sufficed to take the company private. Not much leverage was needed after all.
Charlie Munger would call this tragedy a negative Lollapalooza. But it didn’t have to be this way. In a parallel universe, the CEO could have recognized some fundamental errors in his thinking. Studying the evidence, he could have concluded that speculation is indeed a constant characteristic of stock markets, but over the long term, such markets reflect business fundamentals. And a healthy business generates healthy profits. Even though future challenges are unpredictable, it most certainly helps to face them from a position of strength with as much economic value as possible. Coincidentally, this is also the best way to guarantee stable employment, the one topic that was most important to him. Realizing this, the CEO applied his creativity to find some ingenuous solutions. He helped develop product innovations that inspired the company’s customers. He attacked costs and overcapacity vigorously, and cut his own salary to better align his economic situation to the success of the company. He even listened to some of the suggestions of financial analysts, sold part of the inventory and real estate portfolio, and with the proceeds bought back a significant part of the outstanding shares. The market value of the company reacted almost instantly. Analysts applauded the progress. And employees felt proud again to work at this venerable institution. Many of them decided to buy the company’s stock with their own cash in the stock market, making them wealthy and happy owners.
Charlie Munger would call this a positive Lollapalooza.
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