Warren Buffett and Conglomerates

Berkshire Hathaway is a difficult to understand conglomerate with a collection of unrelated businesses ranging from candy to insurance. Conglomerates suffer a well deserved discount from their pure play peers. Consulting firms like BCG and Marakon estimate the discount as high as 10% in normal times. The discount is based on the following factors:

1)     Poor focus leading to inefficiencies including: a) high head office overhead; b) cross subsidies from cash positive SBUs to cash deficient units; and c) poor capital allocation decisions. Conglomerates mimic capital markets, but on a less efficient basis.

2)     Weak Fit: conglomerates are usually not the best owners of all their SBUs. Managers must not only manage well enough to earn their cost of capital; they also earn more than an alternative owner who can extract synergies from related operations.

These forces underlie the wave of proposed spinoffs by firms such as Hewlett Packard, EBay and Yahoo.  Yet Warren Buffett claims Berkshire’s collection of businesses are worth more under their corporate umbrella than as standalone entities. He bases this on the following:

1)     He can move capital efficiently and on a tax efficient basis among the various units. This is premised on his being a better capital allocator than capital markets. This may be true for him, but probably questionable for other mere mortals.

2)     Spinoffs are frowned upon as the “spin-or” does not receive any premium. There is no premium, however, because, the “spin-or’s” shareholder still own the spun SBU just is a different form.

3)     Berkshire has very low overhead-at least for now.

Well, how can you dispute his success? The success, however, has some question marks associated with it. Consider:

1)     Buffett used to measure Berkshire’s by the growth in book value per share compared to the S&P 500. Unfortunately, Berkshire’s performance by that measure has lagged the S&P index for 5 of the last 6 years. Consequently, he switched metrics to comparing Berkshire market value changes compared to the S&P index.

2)     He justifies the change as better reflecting the significant change in his business model from owning minority positions in liquid public securities (70%+  of business 20 years ago) to owning and operating large business today (70%+ of the current business now).

Perhaps, the conglomerate curse is catching up with Berkshire as it marches down the conglomerate path. Buffett’s superior individual skills may slow the onset of “conglomeratism”. Nonetheless, I doubt that even the Oracle can stave off its effects forever. That may be why he saw it necessary to explain why the conglomerate model makes sense for Berkshire in his annual shareholder letter this year.

Berkshire is unlikely to spin-off any divisions while Buffett remains CEO. My guess is that the pressure to break-up will mount once he gone. It seems that the advantages of the conglomerate model are more evident to those who run them, than to customers, employees and investors.

J

Venture Capital Pricing: Bubble or Something Else?

Trying to make sense of current VC pricing is a daunting task. The increased pricing is reflected in VC IRRs for the past year which exceeded 25% according to Prequin-exceeding those of PE for the first time this century. Consequently, fund raising is accelerating as investors chase yield. This is producing ever higher pricing multiples. Is it a bubble, a recovery or something different?

My thoughts, which focus primarily on the ecommerce segment, are as follows:

1)     There are only three ways to profit from ecommerce. Either you sell devices like Apple, sell goods or services such as EBay or Angie’s Page, or sell advertising –Facebook.

2)     The implicit assumption for investors is competition is weak due to something like network effects-hence the need to raise lots of money, invest it quickly and get big quick. Investors flock to the industry and its participants creating a momentum pricing effect lifting pricing multiples-a virtuous circle.

3)     Wild changes in pricing occur once evidence accumulates that the competitive advantage period is unrealistic. Investors are reintroduced to Porter's  five forces which eventually impact industry profitability.

4)     Investors recognize they misread market signals and have misallocated capital, and begin to curtail investments. This triggers a reverse momentum or vicious circle.

Investor errors are understandable given the lack of operating history or clear business model for these firms. The impact of seemingly small changes in investor estimates can have a major valuation effect:

1)     Simple earnings calculation model: P=E/(r-g) were E is a horizon value earnings estimate, r is the risk factor and g is estimated growth.

2)     P/E ratio is then equal to 1/(r-g). If we assume (r-g) =2 at the beginning of the investment then the P/E ratio is 50. If (r-g) increases to 4 due to a combination of changes in r and g then the P/E ratio falls to 25 resulting in a massive value change.

3)     The change in estimated growth, g, is probably the greatest wildcard. Over estimating growth (AKA under estimating competition) results in investors over paying for growth and reduces their margin of safety when something causes a reassessment.

4)     VC markets, especially early stage, are by no means as efficient as established markets. Thus, the price is not always right. Even in efficient markets the price is not always right. Rather, it means it is difficult to exploit any perceived errors.

The above volatility is characteristic of investors “shooting in the dark” given the lack of operating histories and clear business models for many of these new firms-leap of faith investing. Warren Buffet calls this speculation and not investing-different strokes for different folks I guess.  Until new information arrives, investors are left following technical demand factors (e.g. momentum which is heavily dependent on the amount of new capital raised) and guesswork. Momentum and guessing are prone to error and wild corrections as the mean reversion impact of the Five Forces kick-in.

So, keep your safety belts fastened and do not bet the ranch. The path for now is up, but how long this lasts is unknown. When it changes things will get bumpy as is characteristic of the creative destructive process of economic progress.

J

The Power of Focus and A Sustainable Comparative Advantage

The concepts of focus and diversification are diametrically opposed, but both are crucial concepts in finance.  As investors, we are wise to diversify, to not put all of our eggs in one basket.  As one extreme, employees of Enron who also invested their personal assets in the fast rising company lost both their wealth and their income when the firm collapsed.

For companies (and for individuals considering career options), the opposite is true, and much research has found that those companies that focus on their core competencies are those that prosper.  Companies, like people, have distinct advantages at certain things - but not at everything.  Effective strategic leadership requires defining and honing a sustainable comparative (competitive) advantage.  Let's consider that phrase more fully:

• Comparative (competitive) Advantage means that you can deliver a service or product more effectively, or with higher quality or more inexpensively than your competition.  Now whether you focus on quality or cost is another major decision that we leave for later discussion, but the choice comes down to knowing your marketplace, to understanding customer wants and needs. But as my colleague Joe Rizzi points out, make sure your advantage is comparative: "Having smart people doesn’t mean anything if all your competitors have smart people as well."

• Sustainable - means you will continue to enjoy this advantage for at least the next several years.  This is why Warren Buffett and other great investors talk of finding companies with moats protecting them from competition.  The moat may be in the form of a superior product that cannot be duplicated -  perhaps due to technological knowledge, but more likely due to patents.  It could be from regulatory advantages or political alliances. It could also be from brand capital - the reputation of your firm in the marketplace.  A moat could also exist because of natural barriers to entry like regulation or other legal structures or because the business requires intense capital or other requirements, not easily copied.  There are many more ways to build a 'moat' but the concept is the same, find a way to stay ahead of the competition - a way that is not easily duplicated.

Note that managements can have moats built around themselves as well - a highly undesirable characteristic.  Moreover, management can be so enamored with the size of their empire that they forget the need to focus.  When this happens, external forces - takeovers or activists - step in to correct the situation.  Indeed, the need to focus, to find the sustainable competitive advantage is at the heart of much recent activist activity.  See Joe's recent post discussing Yahoo, Darden, Ebay, Hewlett Packard and DuPont (Royalists Vs. Governistas).  

You can think of sustainable comparative advantage as overlapping circles.  One circle contains the set of all things a company is good at - another partially overlapping circle contains the set of things the market will reward.  The intersection of these circles is the sweet spot where businesses (and people) can prosper.  For businesses and individuals with a sustainable competitive advantage, the sweet spot exists for a longer period of time, but even here the circles are continually moving as technology, consumer tastes, regulation, political climates and other catalysts shift the circles.  It is essential to stay ahead of the shifts.  

Note: for individuals considering career choice, I'd add a third circle consisting of things you enjoy doing.  If you find the intersection of those three circles in your life you are indeed fortunate, doing something you like, that you are good at, that the market values. 

All the best,

Ralph

Royalists versus Governistas

There is a very entertaining professional dispute between corporate royalists represented by the Wachtell law firm and academic governistas represented by Harvard Law School’s Lucian Bebchuk. You can follow it in the Harvard Law School Forum on Corporate Governance. The royalists argue management and the board knows best and should not be pestered by greedy short-term shareholder-activists. The governistas support shareholder-activists actions as a challenge to correct poorly managed firms with weak boards. I support the governistas position on two grounds. First, well run institutions with strong boards have nothing to fear from shareholder activists (AKA the chicken soup defense-it doesn’t hurt). Second, shareholder activists can provide a useful disciple for poorly performing firms.

Some recent examples of useful activist disciple include the following:

1)     Yahoo: the sum of Yahoo’s parts, Alibaba, Yahoo Japan and Yahoo USA, substantially exceed Yahoo’s current market value. This value gap represents the Marissa Meyer, current CEO, discount. Starwood, an activist shareholder sent a letter outlining a litany of issues including poor tax planning bloated overhead, and bad acquisitions. It also suggested a merger with AOL to help resolve some of the issues.

2)     DuPont: under pressure from Peltz’s Trian group to breakup because of among other things bloated overhead. Consider DuPont’s 2012 sale of its coatings division to Carlyle. EBITDA increased from $340 to 815 mm in just 2 years. Highlights inflated expenses and under management the division suffered while DuPont owned it. I hope DuPont kept some of the upside thru a retained interest as Schmuck Insurance .

3)     EBay: finally spinning off its fast growing PayPal division after continuous prodding from Carl Icahn.

4)     Darden Restaurants: another successful Starwood initiative relating to the long under- performing chain. Resulted in the replacement of the entire board and a new management team.

5)     Hewlett Packard: finally responding to long suffering shareholders with the spinoff of its computer division.

Shareholder activists are not always right, but nonetheless, they should not be ignored. The activists are willing to bet with their own capital. Consequently, they have more skin in the game than the royalists. This, for me, makes them more credible.

I do not think the royalists are evil - just misguided. No one likes to be questioned. Also, organizational inertia makes it hard to change from previously successful actions even though they may no longer work due to industry changes.

So in my book it is governistas’ 4-royalist’s 0, but the game is not over.

J