This also ties in with the current Valeant / Allergan drama which I haven't posted about yet. The bearish view is that Valeant's business model is unsustainable.
Many say the same thing about other cost cutters. Popular examples would be Sears Holdings and Hewlett Packard. The consensus seems to be that Lampert cut investments so deeply that it has destroyed Sears Holdings, and Mark Hurd cut R&D so deeply at Hewlett Packard that he destroyed the business.
I'm sure there is some truth in both. When I used to go to K-mart at Astor Place in NYC, the elevator would make a scary, grinding sound. I only rode it when I had to and it only went from the first floor to the basement; I would not have ridden an elevator that sounded like that to a high floor. (I actually love that K-mart. Since we don't have a Walmart or Target in Manhattan, it's great for cheap things you might need.)
And every time I walk into a Sears it was really a sad sight. I actually really liked the kid's clothes at Sears. I thought it was good stuff for the really low prices. But I could get the same sort of thing at Target, Old Navy, Children's Place and many other places (so why would I go all the way to Sears just for that?).
But on the other hand, I'm not too sure more capex to make the stores look nicer would have made much of a difference. Sears seems to have clearly lost business in their respective categories to Home Depot / Lowes, Best Buy etc. And K-mart is just losing out to Walmart, Target and now the dollar stores. Capex doesn't seem to me (and never did) to be the answer, really. A nicer look wouldn't make me want to go to Sears versus Lowes. They are just suffering from a much deeper existential problem.
Hewlett Packard too may be undergoing similar pressures; they could have pumped more money into R&D, but to achieve what?
This got me curious about what many consider the most innovative company on the planet:
Apple (AAPL)
So, let's take a look at AAPL. Just out of curiosity, I looked at AAPL's sales and R&D since 1992. Steve Jobs came back to AAPL in 1997, the iPod was launched in 2001, the iPhone hit the market in 2007 and the iPad came out in 2010.
Surely, Jobs must have come back to AAPL and boosted R&D and spent billions (like other tech companies) to create such great products.
Let's take a look:
Apple R&D History
What is stunning here is that AAPL spent an average $610 million per year in R&D between 1992 - 1996. Jobs came back in 1997, and between 1997 through 2001 when the iPod was launched, R&D averaged only $382 million, 40% less than previous management! OK, so the iPhone is really what shook the world. Between 1997 and 2007 when the iPhone came out, R&D averaged $486 million per year, still 20% less than the previous management. In terms of percentage of sales, previous management spent 6.9% of sales on R&D, and Jobs spent 5.6% over the following ten years until the iPhone came out.
If you only looked at the numbers, you might have been horrified. My gosh, you would say. AAPL is so "has been" that they should be boosting R&D, not cutting it! This is a disaster in the making!
At the time, one of the most innovative companies was Nokia, so let's just look at what their figures looked like around the peak. In 2013, they sold the phone business to Microsoft so I left out 2013.
Nokia R&D History
So these guys, the most innovative company in the world at the time, were spending between four to six billion euros per year on R&D, and double digits as a percentage of sales. Nokia was spending more than ten times as much on R&D as AAPL.
OK, so this is an exception you say. These disruptive innovations are always like this and they are unpredictable. Jobs is also a special case; a super-genius, so we can't use this as a standard for anything.
This is also true. But this would reinforce my doubts about AAPL's long term future (I have no position, but my view hasn't changed since the series of posts I made about AAPL in the past). If Jobs was able to create so much and change the world with less than $500 million per year in R&D, what are they coming up with now spending ten times that amount every year?! Does AAPL now have the big company disease?
Other Companies
Being curious, I took a look at a bunch of other companies considered innovative (and not), and some others that are known for spending a lot on R&D:
Sales R&D R&D%
MSFT $77.8 $10.4 13.4%
AAPL $170.9 $ 4.5 2.6%
Samsung $201.1 $11.5 5.7% (converted at 1000 KRS/$, 2012)
GOOG $55.5 $8.0 14.4%
IBM $99.8 $6.2 6.2%HPQ $112.3 $3.1 2.8%
INTC $52.7 $10.6 20.1%
Sony $45.2 $4.7 10.3% (converted at 100 yen/$, sales exclude financials, film and music)
Nintendo $5.7 $0.7 12.5%
BA $86.6 $3.1 3.6%
GM $155.4 $7.2 4.6%
Toyota $256.9 $9.1 3.6% (converted at 100 yen/$)
Honda $118.4 $6.3 5.4% (converted at 100 yen/$)
So there are some surprises here. MSFT is spending $10 billion per year on R&D, or 13.4% of sales. You wonder where that money is going given their lack of innovation. Sure, there is some stuff going on; incremental improvements etc. But nothing really exciting. And that's after spending $10 billion per year? Again, maybe it's not fair but it's stunning what AAPL was able to achieve with less than $500 million per year.
Sony too spends $5 billion per year, and the iPod should have been their product. GoPro too came out of nowhere and that's exactly the sort of product Sony would have come up with back in the 1970's and 1980's when Akio Morita was still running the place.
GOOG spends a lot, and who knows where that goes. We know they are working on all sorts of things; Google Glass, driverless cars etc.
Owner-Operator Tangent
This AAPL and Sony talk gets me off on a tangent. What's really interesting is that AAPL created the products that Morita would have no doubt created. Why was Sony not able to? There have been a bunch of books on the topic, but at the end of the day, I just think that true innovation is hard with non-founder-owners (I use the term owner-operator, but I actually mean founder-owner). Sony, like MSFT, had certain businesses to protect too; AV business that would have become obsolete due to digitization (which happened anyway!) etc...
(Which makes me wonder, how much of MSFT's $10 billion is actually spent on creating new things versus trying to protect the Windows business? Imagine buggy manufacturers, upon seeing the automobile on the horizon, investing massively in R&D for horse feed that might increase the speed of horses. Is that what MSFT is doing?)
I read a few books written by Tadashi Yanai, the amazing CEO of Fast Retailing (which runs the Uniqlo stores). At one point in 2002, he retired and handed off the CEO-ship to someone he thought was perfect for the part; he understood the culture and what drove Uniqlo's success, was smart, ambitious and hard-working.
But it didn't work out. Why? Yanai said that the new CEO set a modest growth target and got too comfortable. He didn't want to take risk and make drastic actions to further the success of Uniqlo; he wanted to protect what was there and grow modestly with low risk. This turned out to be a disaster for Uniqlo and Yanai had to come back.
Maybe it was a similar story with Howard Schultz and Starbucks. He also retired once and had to come back.
This is what worries me about the generation directly after the founder/owner. A founder/owner will take big risk and take bold actions because he can. Employees can't complain. He is the star. Shareholders can't complain. Suppliers, vendors and customers can't complain. They are all there thanks to this one individual (well, OK, it's all teamwork. But there is usually that one person that attracts the team).
But when a non-founder / non-owner takes over, they can't afford to upset people. They can't take bold actions and take big risks because if they fail, it can be catastrophic. They tend to work to maintain the status quo, or work for modest growth and improvement.
(This is something to think about too with Berkshire Hathaway, by the way. Buffett can afford to take bold actions and goof up since he has so much goodwill (and cumulative performance) built up over the years that even a humongous blunder (unless it destroys BRK completely) will probably be forgiven. Not so the next CEO.)
This, by the way, is why I think Samsung was able to give AAPL a run for it's money while Sony is nowhere on the map: Samsung is still (or was until recently) founder-run and Sony is not.
A really great book written by a founder is: Creativity, Inc: Overcoming the Unseen Forces That Stand in the Way of True Inspiration. Catmull is really honest and discloses a surprising amount of stuff about Pixar in the book. I guess only Catmull or one of the other co-founders would be allowed to disclose so much. But reading this book, it makes you realize how hard it is to create and maintain a culture even when the founders are still there. This makes it feel like it will be very hard to keep up the winning streak without Catmull, Lasseter, Stanton etc.
Other Innovative Companies
We can look at Facebook, Twitter, GoPro and many others; they were created with very little capital. But it's not fair to say that the cost of creating Facebook was a laptop, an internet connection and a college student. For every Facebook, there are many others who try to follow in the footsteps of Michael Dell, Bill Gates, Steve Jobs, and most fail. So the actual cost of creating a Facebook is much higher than that.
I suppose we can argue that that is the case with the recent AAPL too, that Steve Jobs is a special case. Very few people change the world multiple times. So Jobs can work wonders with $500 million and most others can't. But does that mean they can with $5 billion? If they can't do something with $500 million, why should we think they can do it with $5 billion?
Valeant, Allergan, Yahoo
So it makes me wonder, maybe Michael Pearson is right. He has been in the business a long time and has seen a broad view of the pharmaceutical industry as a consultant so probably really understands the waste that goes on in R&D. And his idea is to just spend R&D where it matters; go for the high probability bets like line extensions or alternative uses and forget about the shotgun approach that seems to be common in the industry (not sure if that's still the case but I think it used to be; just do everything and see what sticks).
And perhaps purchasing products via M&A is more efficient than spending a ton on R&D.
Which reminds me that Yahoo's best investments have been Yahoo Japan and Alibaba. I suppose they could have spent the same money in R&D or marketing.
Masayoshi Son of Softbank is like that too; he has made some great bets over the years. I've never owned Softbank or any of his entities only because he is just too far out for me. He told Charlie Rose not too long ago that his stock price went down 99% but bounced back quite a bit.
Well, I tell people don't worry about stock price volatility and who cares what happens to the stock price as long as intrinsic value is growing. But a 99% decline, however temporary, even for me, is too much. We all have our limits, I suppose.
Does R&D Have to be Constant?
Back to the subject of R&D. I wonder if R&D has to be constant. Ackman pointed out that Allergan actually pays the CEO to spend money on R&D. I think that is to deter a CEO from slashing R&D dramatically to boost profits to collect a bonus. So it makes sense at some level. But it also reduces the incentive to make R&D more efficient. It's sort of the opposite of zero-based budgeting; they know R&D will not be cut regardless, because it can't be cut by contract. Is that really the way to run a business?
What would happen if all of the R&D in every company was subject to zero-based budgeting? Every year, you would have to justify every dollar of expense in R&D; why it is needed, the probability of success and potential return etc.
Unfortunately, for competitive reasons we shareholders really can't demand details on R&D spending. But I guess we can demand more disclosure as to how efficient or useful the R&D actually is. What the heck is MSFT spending $10 billion on?! NASA (actually, a panel that includes NASA) says that they can get people to Mars with $80-100 billion in 20 years. That's $4-5 billion per year to get a manned mission to Mars! What's MSFT gonna do with twice that?!
In a lot of companies, particularly high margin companies, it may be that they spend on R&D because they can. Their margins are high enough that even if they spend a ton on R&D, their margins would still be higher than anyone else, so why not spend and see what will come out of it?
Other Costs
So I looked at R&D and innovation (well, not really; I just looked at some raw numbers), but the same argument applies to all other costs. Just because you cut cost doesn't mean you are hurting the business, and just because you spend more doesn't mean you are improving the business. It all depends on what the costs are for. Is the cost really essential, or is it there because the business can afford it? In companies, people constantly need to be promoted so organizations tend to get bigger and bigger.
The guys at 3G Capital have been doing this sort of thing for years (as have, for example, the folks at Danaher) so they understand this very well and obviously have a good grasp of what sort of costs can be cut and which can't.
Even though I have no proof, I tend to believe that more businesses go out of business or suffer due to lack of cost controls (complacency) rather than too much cost cutting (which no doubt occurs too).
Conclusion
Well, there's really no conclusion in this post. Just more questions. I've worked in a big company and understand the resistance to change. Whenever we are asked to cut costs, all hell breaks loose and people fear that all sorts of bad things will happen.
Well, I did experience one bad cost-cutting drive. A company I worked for hired an efficiency expert and all hell did break loose. Suddenly there were no more paper towels, toilet paper or soap in the bathrooms and the hallways went dark as there were no more light bulbs. A bunch of other problems popped up, and it turns out that this efficiency expert was paid a percentage of total costs saved. Duh. So this guy basically just cut everything he had an authority to cut and I think walked away with a nice bonus (or he may have gotten fired before collecting for cause, but I don't even know;either way he wasn't around for too long).
As it says in the Fifer book, the trick is to cut costs that don't add to business and increase spending on what does. It's not about cutting cost across the board.
The problem with middle management is that when someone is in charge of a section or division, it's a rare manager that will work hard to shrink it. Most people want to expand their divisions regardless of whether it's a profit center or cost center. When you go to a budget meeting, who the heck goes, "I want my budget cut 10% next year!".
Sorry for the long, meandering post. Eventually this will turn into an idea and a more cohesive post.
well one area of idea mining would be to look at founder-owner operated companies
ReplyDeleteThat's right. I have been focusing on that a lot here, but only in areas I think I understand. BRK, of course, MKL, FRFHF and the other usual miniBRKs, LUK too until recently... And then Malone entities. I used to own CBS even though it wasn't really a 'founder' situation (well, I suppose the old VIA was). Also things like SEB, CKH and some others. DHR, CFX are like that as are other "outsider" type investments even if some of them aren't really "founder" situations. But a CEO can change the company so much as to make it effectively a whole new entity (like POST) with a different mission.
DeleteMany of the big ones are not areas I feel comfortable, like ORCL, AMZN and others in the tech world. Oh, I do like GOOG, though. I'd take GOOG over MSFT any day just on that alone. Of course, the valuation differential makes it more difficult; MSFT is an interesting value play. I did buy it when it was cheap, but don't own it at the moment. Maybe Valueact is looking to have MSFT slash R&D deeply... (and other expenses).
And looking at owner-operator businesses is not an unknown investment strategy. The folks at FRMO wrote a report about it:
http://www.frmocorp.com/_content/essays/The_Owner_Operator_Company.pdf
And I think they have an owner-operator stock index or something like that... I haven't looked at it in a while but you can google it. I did look through the list for ideas.
Here it is; it's called the Horizon Kinetics ISE Wealth Index or some such:
Deletehttp://www.ise.com/media/95278/ETF_WEALTH_RCH_0514.pdf
It's not exactly founder-owner, but owner-operator... Either way, they share the same characteristics so it should be similar. The index seems to have done really well over time, but I have no idea how much tweaking was done to 'optimize' the index, so who knows what the out-of-sample, future returns will be. The idea makes total sense, though.
i also bought msft and still own it, i agree it was cheap before, now not so much. i would rather own goog as well but like you said valuation make the decision that much harder
Deleteinterested docs will take a look
Disclosure: I work in research and I know about the research in some of the companies you mentioned.
ReplyDeleteYou are right. Most of the research in these companies is not absolutely needed and does not have a high ROI. And as a shareholder and investor I might argue that it should be cut/diminished. On the other hand though, I think that a lot of research is great, it's just not high-ROI. I have followed research conference and journal publications and some of these companies have top papers in the field comparable and sometimes exceeding top universities. So in terms of overall scientific/engineering progress, closing this research would be a big loss.
You could argue that research should be done by governments and not by for-profit companies, but there is no simple or viable mechanism to transfer that money from the companies to universities or government research labs. If companies saved it, at best it would just go to shareholders and I am not Ayn Randian enough to think that shareholders would do the right thing and donate it to the research.
So overall in Allergan vs Valeant, I am mostly on Allergan side, even though I don't think they are going to win since researchers don't own the stock and won't be the ones voting.
With all these arguments, why do you like Google? They are not different from other companies you criticized. They have the advertising cash cow and they are milking it in every way they can. They would get even more milk without research. Their research ROI is no better than others in the field. Even if we say that Android is a research success, which is debatable, they bought it and not researched it inhouse. Their long term projects might be exciting for people, but I doubt they are very reasonable for shareholders. With founder supervoting, shareholders won't even have a say in it.
Thanks for dropping by. I love it when someone actually involved chimes in. I understand your point and I agree with it. But the question becomes how much?
DeleteAs I said in the comment above, sometimes I wonder if people aren't incented to just file as many patents as possible, as if in a patent war. If you are a scientist, I think you would act differently in managing your group if you were rewarded for the number of patents filed versus doing research that you actually believe would benefit society. Do you know what I mean?
I guess what I feel is sort of like what Bill Gates thinks about philanthropy. Philanthropy is good, of course, but Gates questions the effectiveness and meaningfulness of a lot of philanthropy currently done. He wants to really help people and improve their lives; not just give them temporary relief by shipping food and supplies whenever it's needed (he would rather set something up so they can become self-sustaining, for example).
Likewise, in R&D, what is actually going on? Is what is being done really going to benefit society in some way? Is there real scientific progress, or are they tweaking existing ideas and making enough modifications on something so they can file a bunch of patents so they can be in the top patent filers list every year? Is R&D being maintained just because they have to show a simliar R&D% to revenues as peers or they will be deemed non-innovative?
I think there are a lot of questions that can be validly asked.
So I'm actually just poking around with this idea. I wouldn't advocate shutting down all non-commercial R&D or anything like that.
Why do I like GOOG? Well, again, this R&D blog post is just some thing I have been thinking about, but is not at this point a major factor in my investment decisions. But at the same time, I do wonder if GOOG is spreading itself a little thin. And those guys seem to sort of be motivated also by social good, so they may want to invent a driverless car or make breakthroughs in alternative energy just for the sake of social good instead of profits (of course, I'm sure they would want to profit from it if they could).
So yes, I wonder sometimes if they are spreading themselves out too thin and wonder if they might wander too far from a profit-making motive.
But having said all of that, they do seem to be an amazing organization doing some amazing things and they are growing, so it's a little different situation than say, MSFT.
Oh yeah, and as I said in the original post about buggy makers at the dawn of the auto age, it is conceivable that they would have spent tons of money on R&D to figure out how to make horses run faster. And that sort of thing may very well be happening at MSFT, IBM etc... They have businesses to defend, so obviously a lot of capital will be spent on maintaining the status quo. And often, it may actually be totally futile.
DeleteHow much of the patents are actually for new things? It is also conceivable that a lot of patents filed are totally irrelevant. For example, some patents may be specific to products and technologies that are about to become obsolete. Sony's presumably high number of patents related to CRT televisions could be another example. Are they still doing R&D and filing patents in that area? Maybe, maybe not. I don't know. But if you are in a patent war and want to "make the numbers", and you have a lot of engineers with a lot of experience and knowledge in the area, maybe you let them continue to do research and file patents anyway. I don't know if this is happening, of course. But if it is, I wouldn't at all be surprised.
I can imagine similar things happening at all the big companies, actually. And we would never really know.
I know what you are talking about. :)
DeleteCouple comments:
Big revolutionary things mostly don't appear from nowhere. They are usually based on previous incremental research. Take self driving cars. That's based on tons of incremental research into machine learning, planning, sensors, etc, which had to be done somewhere. Some of it was done in universities, but some at IBM, Microsoft, Xerox, etc. So I would not discount working on "incremental things" too much although I agree that ROI is not great.
There's also a big issue of structuring research in a company and attracting good/best people. Their motivation is not necessarily the same as company's motivation, so you might have to choose: go for company's motivation and lose the best people or go for best people and let them to do what they want, which may not be very useful to the company. You can try to mix, but this might work even worse.
I think that Google maybe has managed to deal with this a bit better than others, but even they have some stars that are possibly not very productive.
Anyway, I'd rather not talk about concrete details and companies publicly. If you want to discuss more of this or anything else, email at firstname dot lastname eta gmail
Some random thoughts fwiiw.
DeleteMy (outside) impression is that GOOG has a proper process built around its R&D. They seem to do a shotgun approach but they follow up closely on what works and what doesn't. Things that don't work are cut quickly without many questions asked. Given that nobody knows in advance what the next big thing will be this sounds like a reasonable approach to me. But I might be wrong of course.
The discussions around incentives reminds my of what Charly Munger said ones. He was probably among the top five people to understand the power of incentives and even he underestimated how powerful they can be. Think about your efficiency expert... :-)
Thanks for the Kay video. It's very interesting and he has a good point about invention versus innovation. But he did make it sound like invention didn't cost that much money either back in the Xerox-Parc days; all of it cost $10-12 million in constant dollars per year.
ReplyDeleteAnd yes to the other commenter; R&D has changed. I didn't read it yet but there is an interesting looking book about Bell Labs. There are a lot of Bell Labs / NYNEX scientists working as quants on Wall Street these days. Those research centers did a lot of amazing work and was funded by those monopolies.
I agree research should and must be done, but I just wonder sometimes how much is actually meaningful. I lived through the Japan bubble so maybe I am biased by that bad experience, but back then Japanese companies routinely touted the importance of basic research (basically a label for things that won't create revenues but warns management that it must be done anyway, it seemed to me). And one of the measures they touted was patents filed. At the time, Japanese companies were some of the leaders in patent filings. IBM is at the top, still...
But what happened to those Japanese companies over the years? They are in horrible shape. What are those patents worth?
Sometimes I think when people are incented to do something, they will just do a lot of it regardless of whether they are meaningful or not; kind of like the market share (regardless of profit) wars in the old days in every industry.
Companies loved to tout their R&D expenditure and the resulting patent filings, but nobody ever explains what those patents are and whether they are meaningful at all. If I was an R&D director and told to increase patent filings, I would act in a certain way and make scientists do certain things that would probably not necessarily be meaningful to the company or society in general.
So it's a hard question. I don't mean to say all non-commercial R&D should be shut down or anything like that...
I think the fact Softbank went down 99% post Internet bubble is somewhat irrelevant to what the downside is in it today. It was an Internet bubble stock and then the Internet bubble popped. I agree Masa is very aggressive though.
ReplyDeleteI have a friend who argues that R&D budgets are actually inverse to actual innovation. i.e. large R&D budgets actually kill innovation and don't help it. I think Jobs made some comments to this effect once or twice. Intuitively this makes sense to me as I suspect a lot of things get lost if an R&D organization is too large, bureaucracies form, etc.
I agree with you that Google's culture seems better suited to its R&D strategy, but in general think R&D dollars are massively wasted.
Brooklyn thank you for your excellent blog.
ReplyDeleteJonathan Mills of Metropolis Capital gave a presentation about companies where founders are still involved at this year's London Value Investor Conference. He quoted a study by Bain and Co. that between 2002 and 2012 companies with founder traits outperformed the S&P 500 by three times.
Mills says he likes what he calls "owner occupiers" because they tend to have long time horizons, be good capital allocators, have a customer focus, keep costs down and be restless innovators. A summary of Mills presentation can be found on the Market Folly blog http://www.marketfolly.com/2014/05/london-value-investor-conference-notes.html
Thanks, that sounds right to me.
Deletecan you comment on DTST?
ReplyDeleteHi, sorry I am not familiar with that name.
DeleteKK - do you have links to the Tadashi Yanai books you mentioned?
ReplyDeleteAlas, they are only available (as far as I know) in Japanese... If you can read Japanese you can search on Amazon.
DeleteGreat post as always. Softbank's CEO mention a 30 and 300 year plan. What do you think about companies talking about long-term business plans like Softbank? Do they ever get achieved? IBM is infamous for it's $20 operating eps by 2015.
ReplyDeleteHi,
DeleteI don't know what to think. Masa Son is an incredible guy and has achieved a lot. And I do appreciate his long term thinking. But when he says 300 years, it sounds a little grandiose, grandstanding or whatever. How can you plan for 300 years? What would anyone do differently planning for 10 years and 300 years? What would be the difference? I don't really know. We can't know what the world will look like in 10 years or 300 years so I don't really get it. But I understand the 'spirit' of what he says. He wants his business to survive that long.
IBM is different, though, because that $20 plan by 2015 is just an extension of what they have already achieved with a similar plan before. They lay out a plan and they achieve it. And then they lay out another plan for the next five years and go for it. Buffett said this is one of the things that impressed him about IBM. They say they are going to do something and then they actually do it.
I don't think Masa Son lays out a plan and hits targets, necessarily...
Phillip Morris R&D expenditure: (13/12/11) $449M / $415M / $413M. Now I know rolling fags takes a bit of a knack but I'm pretty sure I could do it more cheaply.
ReplyDeleteWhat Masa means by his 300 year plan is that his company spreads out bets across a wide range of companies/entrepreneurs, which prevents Softbank from the risk that any one technology or Internet asset is disintermediated. It's not that he's really planning for 300 years, but that his business structure provides more optionality/sustainability. He thinks technology changes so quickly and the Internet is so unpredictable that his structure makes Softbank more sustainable than most companies in the space. I think he has a good point and has proven it out with Alibaba, Gungho, Yahoo! Japan, etc. He does actually lay out 3-5 year plans and hit targets. For instance, he laid out a plan to achieve higher EBIT and EBITDA than NTT DoCoMo when he bought the wireless assets from Vodafone several years ago. So what you're saying about Masa not laying out a plan and hitting targets is factually incorrect.
ReplyDeleteMeanwhile, IBM fudges their numbers on EPS by all kinds of financial permutations, i.e. selling businesses to include the number in their EPS, non-GAAP accounting, etc. Look at their cash flow statement, it is a disaster. Jeff Mathews blog takes them to task pretty well.
Hi,
DeleteThanks for that. Yes, you are right; Masa does set targets at the operating level, just not for all of Softbank, I suppose. It's interesting that he talks about optionality/sustainability when he was very levered up in the 1990's. It's a wonder he got through it borrowing against his internet holdings. I guess he learned his lesson and won't be doing that again. The guys I follow who are levered usually levers against steady (or at least steady-ish) cash flow.
Maybe Son is past all of that now. But he does tend to bet big so his style is not for everyone.
And yes, IBM does all sorts of things to make the number as do a lot of other companies. I rather they don't do things like that, but for me, the important thing is the quality of the business and long term potential. GE is well-known for fudging numbers for years during the Welch period, and Welch even admits in his book that he loved his direct reports because they can go and find and extra penny here or there when they were running short on a quarterly number; he will let someone book an order early in this quarter or do something in GE Finance (which was sort of an accounting cookie jar).
I don't think that's the reason why GE stumbled. They got killed like all other financials for the same reason.
Also, even JPM does some fudging too. To offset some of the whale loss, they realize some unrealized gains in their securities portfolio. It did absolutely nothing to the economics of the business except make the EPS figure look a little better. If you look at their huge charges over the years, there are often gains against it (selling Visa shares etc...). So that's sort of fudging in a sense.
American Express had an uncanny run of special charges that were beautifully offset by one time gains, and this went on for a long, long time.
There are a lot of other examples.
But I still think AXP and JPM are amazingly well-run companies and I don't really hold all that fudging against them at all. What's really important to me is the underlying quality and outlook of the business, not what happens in the short term. Sometimes this fudging happens to smooth over rough times and a bunch of one-time charges/expenses, but if the business despite the short term bumps still looks good over time and the fudging isn't fraudulent (falsely marking up the book or whatever), it's not that big an issue for me.
Anyway, thanks for pointing out my error.
Twitter and Facebook weren't created with very little capital. In fact, they took in enormous amounts of funding. Twitter is still burning money.
DeleteIt sure took more than a laptop and a dropout for sure, and you are right, I suppose it took a lot more capital to get FB up to profitability, but I'm not sure how much. As of the IPO, total paid in capital as $3.3 billion, and cash/marketable securities was $3.9 billion. I think a lot of the late stage funding sat on the books as cash.
DeleteIn any case, the value creation has been pretty incredible in any case, and that's the point. But then again, these are rare events.
Didn't mean to "point out an error," just think Masa is misunderstood a lot of the time. Now Masa has 2 assets with recurring cash flow to lever up, so maybe he has the goods now more than before. Albeit he still needs to turnaround Sprint.
DeleteThought the original post and the more recent one too were very good and helped me think about business issues and investing.
My take is that IBM has been poorly managed for years, I speak to a lot of tech company mid-level executives and consistently get feedback that IBM bought such and such company and "it went away." In other words, they buy these software assets that were good assets and then the companies disappear inside IBM. So my problem with IBM isn't that they are fudging their numbers per se, it is that the company is deteriorating and they are trying to cover it up to some degree (not sure to what degree).
Anyways, thanks for the thought provoking posts, appreciate it, keep up the good work.
KK,
ReplyDeleteI work in Silicon Valley. Apple is a fashion company - its products have sex appeal and are a highly desired fashion accessory. For example, nobody knows if they even have a CTO, but they have a design guru - Jon Ive. Microsoft/Intel/Google are genuine tech companies. Apple is like Louis Vuitton or Coach (handbags).
The R&D/technology that goes into Apple's products is very little because there is nothing new there. What is new is the sleek packaging - for example, people like the exterior of Apple's devices - they are better to look at than the competition.
Hi,
DeleteThat's a good point. It's more of a consumer electronics company, maybe. It also relates to what Alan Kay calls innovation versus invention. Apple innovates but doesn't invent.
There are varying degrees of black and white here, but I tend to give Apple a little more credit than a fashion company as it's more than just the look that got Apple where it is. Maybe the technology already existed, but the iPod was better (functionally too, not just looks) than anything out there at the time, and so was the iPhone which was revolutionary to end users regardless of whether or not there was anything technologically new. It was a huge leap. The iPad was an extension of that.
Apple also does create it's own operating system and other software, so it's definitely not just a pure assembler like Dell, for example.
But in any case, they are spending a lot now on R&D, so maybe there is more science now than before. But let's see where that goes!
Thanks for posting. I always appreciate thoughts from 'real' people (as opposed to us financial folks who see everything through balance sheets and cash flow statements!).
Very thought provoking post (read: financial poetry as usual from BI)
ReplyDeleteWhile reading it I thought of:
All of these companies are already mature, in the sense of multiple innovations, they are not one hit wonder. In other words there's a clear proof for the CEO abilities.
If someone has that ability for multiple innovations and entrepreneurship, there's a higher chance they'll start their own company instead of working as CEOs for someone else.
Having said that, it would be interesting to find innovative companies without founder owners who managed to continue to innovate.
Apple almost BKed at one point and was saved by MSFT (which wanted to avoid patent wars) so this might also be a double edged sword where companies got burned by a too enthusiastic CEO. I know a few small companies like that who never lived long enough to become big companies due to the founder owner's "vision".
R&D costs in these companies are often personnel costs, right? I'm wondering if Nokia being a finnish company means they would have higher R&D costs almost by definition due to local regulation (higher social benefits etc. then again salaries might be lower)
BTW about Uniqlo, in the past year or two there's a clear downward trend in the quality of their products, it's becoming more and more like trash and other brands such as Gap are fighting back with pricing. We'll see how that ends.
Most tiny companies and micro companies have owner founders, if we follow your argument, could it be one of the reasons for the higher upside in small companies (other than obvious reasons of marketcap etc.)
Thanks again for sharing your beautiful poetry with us mere mortals :)
Hi,
DeleteThanks for the comment, but poetry? I have never gotten a good grade in English, ever, and if any of my former English teachers read this, they would be ashamed, lol... and I know it's not great writing. But I appreciate your thought. I guess there is something casual and email-ish about it that makes it easy to read even if not grammatically correct much of the time.
And yes, this is more of a thought provoking post than anything definitive or factual.
You have a good point about mature companies. And I am not entirely dismissing the value of non-commercial R&D, but I wonder of all theh patents and inventions/innovations going on at the big companies, how many of them are actually meaningful at all even commercially or non-commercially (social benefit).
I wonder if people just don't maintain a certain, fixed percentage of R&D to sales just because of their competitors, or institutional inertia. Those are the things I wonder about.
And yes, small companies are mostly owner-operators, but there all types, right? Even the guy selling hot dogs from his food cart (even though most of them these days tend to be employees; they don't own their own food cart) is an owner-operator, as are many ice-cream trucks.
And obviously, the start-ups have high risk (venture capital), so it's not an easy business to find the future winners. That's why the established owner-operator or founder-operator busiensses are so attractive.
And thanks for your input on Uniqlo. I can't judge fashion at all. I have never seriously considered buying Fast Retailing stock anyway so it's not an issue for me. What turns me off is the industry itself (highly unstable with trends coming and going; Gap ruled the world once and then it didn't etc... I LOVE H&M and Zara too as stores, but they too will come to a saturation point with many other competitors adopting the 'fast fashion' model.
Plus the fact that Uniqlo stumbled once when Yanai retired is a big, bad sign for me. He will eventually have to go again at some point and I would hate to be a stockholder on the day it is announced. Plus his huge ambition is scary. I tend to think Japanese companies have awful M&A track records overseas. The only way Yanai is going to hit his target is a huge deal, and that scares me.
Also, I tend to think that H&M, Zara etc. did well globally because they had to be competitive in multiple markets with different tastes from the beginning. Japanese and U.S. retailers have huge domestic markets that they adapted to which sometimes doesn't travel well... H&M/Zara/IKEA didn't have that problem; they had to adapt to different markets from day one. Once you get too big, it's hard to start to adapt. I think that's why Gap didn't do as well as say, H&M. And Uniqlo too.
1. I don't think that Jobs was the genius that he pretended to be; I think that the Apple cult is built on mostly on nonsense.
ReplyDelete2. If you go to youtube.com, you can find a old tape of Jobs answering questions at a company meeting shortly after he announced a large cost cutting program - this would have been a few months after he returned to the company. Essentially, he tried to explain to disgruntled employees why it was that he was canning some of their pet projects. Some of the things he said there made sense (which would be in contrast to the BS he usually spouted).
Someone at Microsoft must have read your post. Any thoughts about the new CEO? Would he be a "product guy" in Steve Jobs eyes?
ReplyDeleteHi,
DeleteFunny about the timing, but this big cost cutting has probably been in the works for some time (so has nothing to do with this post). I don't know, the new CEO looks promising and he is saying the right things, but I have no idea if he can make the changes that seem necessary there. We'll see.
This is as good of a place for me to ask about your thoughts on The Outsiders. I read it, and respect a lot of the things in it, but found too many examples veer too much to companies (and CEOs) that basically sold out or got bought out, and the fortuitous timing of the sale/spinoff/merger/etc. When there's an exit, especially during a bubble, that's bound to yield great looking numbers.
ReplyDeleteAs much as the secret is capital allocation, for many of the (non Berkshire) CEOs, the biggest chunk of the returns came at good exit price. That kind of bothered me a little.
Hi,
DeleteThanks for the great question. That's a very good point. But selling out is all part of the rational behavior of these CEO's so it doesn't bother me at all. The alternatives are not accepting a deal at a high price and then posting mediocre returns going forward for the shareholders (for example, Yahoo's rejection of the MSFT bid).
These CEO's sell stock at high prices to fund acquisitions and repurchase shares cheap to return capital to shareholders etc., and to me, selling is all a part of that so it's not a big factor.
But are these CEO returns just a function of great timing/selling in a bubble? Actually, I think not. I can think of some billionaires that sold that young companies in 1999 and I agree those guys seem to be lucky (well, they did put in some work too, but...).
Is the well-timed sale a "big chunk" of the returns? Actually, I think not. I haven't done a detailed analysis, but you have to remember that these CEO's have performed very well over a very long period of time.
A quick calculation from my table in the original post shows that these CEO's on average served for almost 30 years and far outpaced the index.
Now, if you got lucky on the exit, say, you get to sell the firm for TWICE what you think it might have been worth, it looks like the CEO created most of the wealth on that day (a good 50% of the total value is due to overvaluation).
This is not to say that that was what happened. Just as an exercise, let's just say that the companies were sold for twice fair value.
Yes, on a dollar basis, it looks like most of the wealth was created by the exit.
But let's look at it another way. How much of LONG TERM RETURN is due to the high exit price?
That's easy. Assuming we are looking at 30 year returns, selling a firm for double it's fair value at the end of 30 years would add 2.3%/year to the return. Yup, just 2.3%. Over 20 years, it's 3.5%/year.
If you look at the long term returns of the CEO's, 2.3% or 3.5%/year is not a "big chunk" of the overall return.
Just to illustrate, let's say a company has a book value at $100 and it earns 20%/year for 20 years. Book value at period end is 3833. That's 20%/year. What if this CEO gets lucky and gets to sell out in a bubble and gets 2x book value. Then he sold for $7666. So yes, it looks like he made as much money on the exit as he has made in the previous 20 years! Lucky bastid!
But what we are interested in is long term returns, right? So from $100 -> $7666 over 20 years is 24.2%.
So this CEO's performance of 20% was boosted to 24.2% thanks to the high exit price. That's not really a "big chunk". Even if he sold out at book value with no bubble benefit, it would be impressive.
Over 30 years (which is the Outsider CEO average tenure), this bubble "bump" would be even less.
You can try this with other figures; 2x, 3x, 4x etc... and see what you get.
I think you will find that the CEO performance was pretty impressive even considering a high exit price.
But then again, I go back to what I said in the beginning; selling out at a good price or a great price is as much a part of good capital allocation as anything else, I would think. (Just ask YHOO shareholders from a few years ago!)
Thanks for reading, and thanks for the great question.
I won't beat this to death. I think, in principle, what Thorndike views as the CEO's virtue are exactly correct, basically do whatever you can to increase shareholder value, with capital allocation decisions offering great tools to do so.
DeleteAnd I was going to go through the CEOs Outsiders profile, but I think my point can come across just by going through the a few, in order of appearance.
Tom Murphy and Cap Cities - for the first 20 years it was basically dead even with comp group, and the outsize returns started in 86, with ABC acquisition, and a huge part of it was also due to the sale to Disney. (for example, what would Disney's return be in that same period?)
Singleton and Teledyne - for the first 15 years or so, looks like it was dead even with the comp group too, but '75 was the start of the buyback and also increase involvement in insurance investment, during a bear market.
With GD, Mellors (93 - 97) seem to match S&P, and likely trailed comps, and even taken the whole period (which included 3 different CEOs), outperformance was +5% of comp group, I don't think it's excessively compelling.
Malone and TCI, I have less to quibble about here.
Graham and Wash Post, doesn't look like it did much during the first 10 years, which changed in 80s, which coincides with main competitor closing, and investments in cellular and cable? which... in that case, I don't know, luck? Invest in cellular and cable instead?
At some point, even while agreeing with the belief that capital allocation should be an important part of CEO's duty and how it affect shareholder return, I feel Thorndike's research or presentation is cherry picking, biased, or somehow forced. Something is not exactly kosher, that's the nagging feeling I got while reading (among other nagging thoughts), and I think this post just confirms it (for me).
Part of this was just looking deeper at Post and Stiritz (thanks to your posts on Post), and then reading the Stiritz chapter, and looking at the chart in the book that showed the outperformance occurring in 2000-2001 and the buyout of Ralston. Even with that, it was just 2.5% over Stiritz's peers.
Oh, I would be remiss if I didn't add that it's ironic that (historically) Buffett is most hesitant to use the main/easiest capital allocation tools, buybacks and/or debt to fund the buybacks. I mean, could you just imagine the difference? I'm sure he (or Munger) has discussed this before, but seriously, why?
DeleteFeel free to beat it to death. Opposing views are always welcome here. I see your point. I thought that about Good to Great and some of those other management books (but after reading about 3G Capital and seeing Brito pound the table on how great a book it is, I have to read it again).
DeleteI understand your point and I feel that way about a lot of things out there. For me, I am not that skeptical because these CEO's are actually highly regarded CEOs. It is cherry-picking in the sense that he chose great CEOs, but that's sort of the point so you will always sort of have that hindsight bias. The key is to figure out if there is something there that is more than chance and some common threads and in that, I do think that the book succeeds.
As for the performance, I haven't looked in detail year-to-year so you may have a good point there too. But great CEO's need not have the share price outperform in every time period. Teledyne's flatness starting from 1965 is not surprising given that the stock market was flattish since then through the early 1980s.
The key is if the CEOs were able to increase the intrinsic value over time; the stock price may not reflect IV consistently through time. Hopefully, though, by looking at returns over long periods, the end-points become less relevant (starting point, end point of return calculation). And over time, we assume that the stock price has reflected IV... (again, if the end point stock price far exceeded IV, it would only push up long term returns a little bit as illustrated in my first response).
Even BRK has had flat periods in the stock price while IV kept growing.
So I wouldn't be overly concerned with that.
Anyway, if you take a closer look at these CEOs, there are probably many things like what you say, and people will have various opinions about it.
At the end of the day, though, if you look at what those CEO's have done and see what the typical CEO does, that contrast is what really is striking to me and there is something there to learn from.
As for Buffett/share repurchases, I did wonder about that too. If BRK acted more like Loews and repurchased tons of shares, BRK might be much smaller now, and if it was much smaller, imagine what Buffett could do in terms of investment performance.
The problem with that is that I think it has been rare for BRK to trade cheap (only once in 1999 before the recent run of cheapness). The stock has been cheap in the past few years, but there is no liquidity so it is questionable how much stock BRK could have bought. BRK needs to put billions to work. I don't think he can buy billions of BRK stock since it's so illiquid... IBM BRK is not.
Also, if BRK kept buying back shares over their history, how much would Buffett own? His ownership percentage would go up, perhaps to a point that he would not feel comfortable, but I don't know if that's a factor...
Anyway, thanks for the discussion. I know that for any book, CEO, investor or just about anything, there will be varying opinions about it so it's good to hear what others think.