The Ugly Ducklings!

(Continuing on the wonderful compilation of Warren Buffett's sayings done by Bud Labitan called "The Warren Buffett Business Factors" but unfortunately the link I had recorded is broken.)

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. 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. Also, it 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 brainpower 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.

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, 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.

Taken from The New Buffettology :

Investing in Burlington in a market downturn or on bad news isn't a great move if the long-term growth is the goal. It is the kind of investment that Warren steers away from because it lacks the durable competitive advantage other companies can offer.

Warren is fond of saying that when management with an excellent reputation meets a business with a poor reputation, it is usually the business's reputation, it is usually the business's reputation that remains intact. In other words no matter who is running the show, there is no way to turn an inherently poor business into an excellent one. Ugly ducklings only grow up to be beautiful swans in fairy tales. In the business world they stay ugly ducklings no matter what managerial prince kisses them!

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Ugly ducklings only grow up to be beautiful swans in fairy tales. In the business world they stay ugly ducklings no matter what managerial prince kisses them!

How true isn't it?

Take the toughest industry... for example the airline industry in the US. Here is my favourite comment on it from Charlie Munger (The Art of Stock Picking)

If it's a pure commodity like airline seats, you can understand why no o­ne makes any money. As we sit here, just think of what airlines have given to the world safe travel, greater experience, time with your loved o­nes, you name it. Yet, the net amount of money that's been made by the shareholders of airlines since Kitty Hawk, is now a negative figure ‑ a substantial negative figure. Competition was so intense that, o­nce it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.

Now you can the smartest and most innovative management running the airline, but no matter how good and how dedicated they are, a terrible business remain a terrible business.

And here is more comments from Mary Buffett's book.

In 2000, it was reported that United Airlines, one of the best-run airlines in the United States, carried a net debt of USD$5 billion versuse USD$4 billion in net income the last 10 years. Unions and high fixed costs ensured that any airline flying the friendly skies will never allow their shareholders' riches to soar for very long.

And what about the terrible automobile business?

In 2000, GM carried approximately USD$136 billion in long term debt, a sum greated than the USD$34 billion it earned from 1990 to 2000. Imagine, if you took every dollar that GM made for the last 10 years down to the bank, you still couldn't pay off the loan. Doesn't sound like a great business, does it?

For the car industry, they have to spend tons and tons of money designing and researching on new models. Then they have to spend tons of money to market the product (the car). And after all the moola spend, when the car hits the street, their nearest competitor comes out with a similiar competing design. How? Does it matter who is managing the business? A lousy business will most likely remain a lousy business because the economics structure of the business industry does not alllow the business to be good!

Anyway, the GM example also highlights the issue on why it is so risky owning business which carries such a huge debt. Just imagine if we own such a company which carries this sort debt. Now if and when the boom time is over, what will happen? Well, when the boom is over, sales and profit will most likely decline. And the decline might turn into losses due to financial interests incurred by the company carrying those huge long term debts.

So let me remind myself again...

Ugly ducklings only grow up to be beautiful swans in fairy tales. In the business world they stay ugly ducklings no matter what managerial prince kisses them!