Any parent who reads to their children at night will enjoy picking up Dear Chairman and going chapter by chapter with their little one. Your child may currently enjoy some version of Shrek or Trolls, but with persistence, I am sure a good parent could point her in the right direction.
Dear Chairman is a collection of stories where investors seek to find value in companies and then proceed to “unlock” this value by persuading management to do what these investors think is right. Jeff Gramm, the author, does a great job of including background details that make the business stories even more interesting. Additionally, I enjoyed the chapter about things that didn’t work out.
The essence of this debate regarding activism can be summed up in this brief passage:
“Managers will be biased toward self-preservation, while shareholders are easily persuaded by short-term profits. In an ideal world, the board of directors is able to negotiate these biases, but, in reality, it often just defers to one side. The results can be ugly.”
I wanted to discuss a few chapters.
Graham and Northern Pipeline:
Ben Graham’s investing style resembled a man with a treasure map. If he could just find the treasure in some deep dark corner of the stock market, he would be rich. The treasure hunt is called information arbitrage today where Graham, through his study of financial filings, led him to information the market did not have.
“The year was 1926, and Benjamin Graham was sitting in the Interstate Commerce Commission (ICC) reading room in Washington, D.C., studying Northern Pipeline Company’s balance sheet. Nobody on Wall Street— not even the brokerage houses that had followed Northern Pipeline for years— had bothered to look up the company’s public ICC report. As the stock languished at $ 65, the report revealed that Northern Pipeline generated over $6 per share in annual earnings and owned millions of dollars of investment securities worth $90 per share. Benjamin Graham described the feeling years later in his memoir: “I had treasure in my hands.” All he had to do now was convince Northern Pipeline’s management to share the company’s wealth with its stockholders.”
I think this is a great historical read, but I think this situation rarely applies today. In fact, I think this approach sometimes creates bad investment decisions because investors think they have struck gold, finding assets tucked inside bad businesses, only to realize (hopefully, sooner rather than later) that the bad business will quickly eat away at any value these hidden assets once had. Take Sears Hometown and Outlet stores. The value of its inventory, net of all outstanding liabilities has been around $400m for the past few years. A few years ago, the whole company was worth about $400m, but has slowly accumulated losses over the years. Today, the inventory is still worth around $400m, net of all liabilities, but the company is worth around $100m. The company should obviously be shut down, but I am not sure it ever will be. I have read multiple write-ups over the past few years pointing out this value gap, but the business continues to be one where wasting assets will eventually close that value gap, but not in the way that will make investors any money.
Ross Perot and GM:
Ross Perot’s time on GM’s board is what you would imagine if you ever watched any youtube video of Perot discussing any sort of fiscal policy in the U.S. His rational thinking is a great escape from the saying nothing political world in which we now live. The great takeaway from Perot and GM is a vivid, albeit brief, description of the institutional imperative, i.e. big corporation laziness, that can occur when companies become fat and lazy. Take this excellent quote from Perot:
“I come from an environment where if you see a snake, you kill it. At GM, if you see a snake, the first thing you do is go hire a consultant on snakes. Then you get a committee on snakes, and then you discuss it for a couple of years. The most likely course of action is— nothing. You figure, the snake hasn’t bitten anybody yet, so you just let him crawl around on the factory floor. We need to build an environment where the first guy who sees the snake kills it.”
Economies of scale are an advantage until they are not. Buffett and Munger have done a great job of guarding against this problem with a decentralized corporate structure. However, some of Buffett’s investments in public companies may be getting a little chubby, American Express and Coke, come to mind. This article is a good one that highlights some of the “fat” at American Express:
When Chenault made the reverse trip to Issaquah, the Costco guys were tickled by how meticulously Amex choreographed his movements. “Ken Chenault would have an advance team come to our office before he visited,” says Paul Latham, Costco’s vice president for membership and marketing. “They planned everything—where he would enter the building, the route to the boardroom, where he’d sit at the table.”
Could you imagine Buffett or Munger having an advance team?
I wouldn’t be surprised, if Buffett’s modern day partner in crime, 3G Capital, took a run at Coke.
This chapter highlights a few different principles important to investing. First, R.P. Scherer had a great business producing soft gelatin capsules.
“By 1940, he was the patent-protected, low-cost producer of softgels, with a 90% market share. He also developed tremendous expertise that widened the competitive moat around his business. In the early days, his customers would bring him medicament, and he would encapsulate it. Within fifteen years of launching his business, most of Scherer’s customers had him formulate their capsules as well.”
However, the founder died when he was only 53 and his son, along with other successors, proceeded to “diworsify” the business.
“Scherer was succeeded by his headstrong twenty-seven-year-old son, Robert Jr., who became president of the company. Robert Jr. made his first acquisition for R. P. Scherer just one year after assuming leadership. In 1961, he bought E. Morris Manufacturing, a Detroit barber products supplier that got its start importing straight razors from Germany. 12 He proceeded to buy a dental supplies business, a surgical instruments company, a 25% interest in an aloe vera cosmetics maker, a business that made steel cabinets and chairs for ear, nose, and throat doctors, and two companies that made bobby pins and hair curlers.”
Empire building is a cancer on many organizations that see revenue growth instead of return on investment as the ultimate goal. It never ends well.
The second business and life lesson for this chapter is how incentives typically rule the day. R.P. Scherer’s daughter (Kara) tried to wrest control of the company from its horrible CEO (her husband and soon to be ex-husband), but the board members were highly paid and saw Kara’s strategy to sell the company as an end to their gravy train board jobs. Remember Sinclair: “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” Interestingly, the Chairman of the Board at R.P. Scherer earned the following compensation:
Mack was the chairman of R. P. Scherer’s board of directors. The company paid him almost $400,000 in cash the year before Karla’s proxy fight (roughly $800k in today’s value). In addition to his hefty annual cash compensation, Mack received stock-based rewards as well as generous benefits including club memberships and secretarial support. Upon his death or disability, he was entitled to benefits worth $ 42,000 annually that were payable to him or his wife as long as either of them lived. 31 According to Karla, Mack acted as a father figure to Peter. He was seventy-seven years old and Karla believed his duties at the company were “largely ceremonial.”
[As a side note: the CEO of Taro earned $800k last year with a potential for a $400k bonus. No stock options or other compensation. Taro earned roughly $600m in pre-tax operating income, whereas R.P. Scherer earned around $30m in 1988 (or $70m in today’s value).]
Is it any wonder that Mack voted against Kara?
Incentives matter. This chapter is a great examples of how incentives can distort outcomes.
The chapter on Buffett and American Express is a great one for background, but I am working on a separate post about his investments in American Express and Geico. However, I did like this remark:
“Buffett was constantly refining his investment style, even toying with short selling and pair trades at one point. As he told the New York Times in 1990, “I evolved. I didn’t go from ape to human or human to ape in a nice, even manner.” Buffett learned lessons from his mistakes as well as his victories. His biggest triumph was American Express. It proved to be a major turning point in his career.”
You can read that 1990 article from the NY Times here.
Matt Brice is the portfolio manager of The Sova Group, LLC, an investment firm that manages separate accounts for clients. Matt can be reached at firstname.lastname@example.org.