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Some thoughts on company management
Today I want to discuss the issue of whether excellent management can, in general, overcome the factor of a very poor economic position, without competitive advantage, and therefore without pricing power and decent rates of return.
This leads on to the difficulty for us investors when examining a company going through a hard time to decide whether its recent poor performance is due to a fundamental flaw in its economic position or due to a temporary problem that can be remedied by the application of excellent, or even just normally competent, management actions.
The business franchise factor generally overpowers the managerial quality factor
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. (Warren Buffett, B.H. Letter 1980)
Comment: After long experience in investing in shares valued at a very low price relative to net current asset value Buffett came to the conclusion that there are often rational reasons for the low price, and that an increase in market capitalisation is unlikely even if excellent managers apply themselves vigorously to the task.
The main cause of such a failure is the absence of any economic franchise. There is no pricing power and very little likelihood of one emerging from the efforts of managers.
For example, some industries have an abundance of competitors each of which cannot implement price rises for fear of customers simply switching to identical or near-identical offerings from competitors. Also, the industry is wide open for new entrants to try to take market share, and suppliers may hold the upper hand in bargaining on price because they are operate oligopolistically. And there might be plenty of substitute ways for customers to obtain the same outcome.
Wholesaling electronic products
Northamber (LSE:NAR) a wholesale distributor of electronic goods, which has just reported greatly increased annual losses, illustrates the point on absence of economic franchise – but it does not have brilliant management either. They continue to invest in the same industry despite years to losses, which get worse year by year.
When buying electronic bits and bobs, such as printers and routers, there are any number of wholesalers for customers to turn to. If by some chance the industry became profitable enough to afford a decent ROCE there will quickly be new entrants pushing down prices again. The major brand name manufacturers control the low margins of the wholesalers because of their power.
An example of an industry with some brilliant managers but very poor economics
The mid-market car industry produces very poor returns on capital – many companies report losses year after year. There are dozens of alternatives for consumers to switch to if one brand raises prices – there is low customer captivity.
There are regular new entrants to the industry looking to build market share (watch out for the Indian producers over the next decade) which helps to hold down prices.
Suppliers frequently have power over prices such as the limited number of car-system suppliers to the assemblers (fewer small components are bought these days, more systems are bought for final assembly).
Even substitutes are a threat, e.g. many cityfolk choose not to buy a car at all, opting for public transport, Uber, car hire, car share, walking or cycling.
Distinguishing between a sound franchise going through a temporary low-profits hard time and a company with little hope of ever climbing out
Extraordinary business franchises with a local excisable cancer (needing, to be sure, a skilled surgeon) should be distinguished from the true “turn around” situation in which the manager expects – and needs- to pull off a corporate Pygmalion. (Warren Buffett, B.H. Letter 1980)
Investor skill is needed to adequately separate the sheep in terms of short-term low profits due to, say, recent mismanagement or an external market hit, but where long term pricing power is still in place on the one hand, from the goats of perpetually low profits in a company that is very unlikely to ever turn around.
Buffett manages this separation by doing some very basic, but profound, research.
For example, he suspected that Disney in the mid-1960s was a high franchise value proposition despite temporary problems. He confirmed his suspicions by asking around, by observing children and adults still enjoying the products (he sat in a cinema watching Mary Poppins) and by being farsighted enough to realise that the library of films, TV programmes, etc. could be used over and over again at little extra cost, and in a hundred markets around the world.
Similarly, American Express lost credibility with Wall Street analysts when it was taken for a ride by a fraudster. But on Main Street it had customer captivity. Buffett could see that people still used American Express cards at his favourite steak house, that they still loved using AMEX traveller’s cheques.
Likewise with GEICO insurance in the early 1970s. Some recklessly gung-ho managers had lowered prices on insurance to the point of unprofitability and the near death of the firm. Warren discovered that customers still trusted the brand. It still had a low-cost distribution model and with an excellent manager in charge it could be revived – a Pygmalion.
On the other hand there are companies such as the original Berkshire Hathaway textiles or Dempster Mill which never could be revived properly because they lacked pricing power.
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