Many
of us who claim to be long-term investors (LTI) worship at the feet of Warren
Buffett and actually own shares in Berkshire Hathaway as I do both personally
and in the private financial services fund that I manage. While “the Sage of
Omaha” claims his favored investment period is forever, as noted in a recent column
by Chuck Jaffe, a study of his actual
publicly-traded portfolio transactions suggests a holding period of four to
five years. I suspect his two relatively new portfolio managers (who like Mr.
Buffet have a background in managing hedge funds) have a shorter period of
satisfaction with their holdings.
Corporate CEOs have little true confidence in the steadfastness of their institutional shareholders, with the possible exception of index fund holders if the companies are cursed or blessed by being found within one or more indexes or ETFs. Assuming no large earnings or other shortfalls, most particularly large corporations have the same CEOs for five years. In terms of transformational investments, ten years is a reasonable planning period to examine the success of many companies. For those businesses that make large capital expenditures in fixed plants or ground-breaking R&D, particularly in pharmaceuticals, twenty years or even longer is a reasonable measurement period.
Those of us who are investing for the education and future of our grandchildren will take our money to the ultimate fulfillment. For those of us like me that serve on boards and investment committees of large tax-exempt groups that are responsible for universities and hospitals, the time horizons are even longer. Think about granting tenure to a forty year old professor who could be teaching for forty or more years voluntarily and an administration without an easy ability to either improve the quality of the teaching or cutting the expenditures. As far as hospitals are concerned, the outer skins of the buildings are likely to hold up for fifty to one hundred years, that is if they weren't built to federal government specifications and by low-bid contractors. However, with the marches of science and regulations many if not all of the physical plants will have to be reworked rather frequently due to perceived obsolescence.
Faulty starting points of too many LTIs
Too often we become captives of both history and the headlines of the day. Any study of past investment mistakes shows that over-confidence in our wisdom and our ability to foretell the future leads to disastrous results. I have learned through meetings with existing and potential investment managers and investment consultants that many confuse the difference between a book report and a book review. The report form abbreviates the history of their investments both statistically and thematically. A review has to do with the ability of the managers to successfully negotiate the future, or more importantly futures. I am in the continuous process of meeting with existing managers that we use and candidates for future use. To the extent that the portfolio managers and their chief investment officers (CIOs) think deeply about the future or futures, I will be probing them with some of the questions shown below and other items they or I think are important. In addition, I ask the readers of this post to react to these queries publicly or privately.
For the sake of the future, "Are profit margins too high?"
This is not a mirrored concern of my good friend Byron Wien and others that are worried that margins will surprise many by coming down in the second half of the year. My concern is different and perhaps deeper. As an entrepreneur I know that profit margins are not just a result, but to some extent are the outcomes of a very important series of operating asset allocations. Final operating margins are the consequence of a series of simultaneous equations between personnel management, development spending, foreign exchange management, balance sheet concerns and the mix of interest received and paid. Often margins are the beneficiaries of past acquisitions bringing the acquired margins up to the level of the new corporate parent. The simple statistic of profit margin does not reveal enough about its present and future composition for wise investors to properly evaluate the investment's long-term attractiveness.
Why can margins be too high?
I am not a socialist, but I raise the question, “As a society, outside of government, are we paying too little to employees?”
Corporate CEOs have little true confidence in the steadfastness of their institutional shareholders, with the possible exception of index fund holders if the companies are cursed or blessed by being found within one or more indexes or ETFs. Assuming no large earnings or other shortfalls, most particularly large corporations have the same CEOs for five years. In terms of transformational investments, ten years is a reasonable planning period to examine the success of many companies. For those businesses that make large capital expenditures in fixed plants or ground-breaking R&D, particularly in pharmaceuticals, twenty years or even longer is a reasonable measurement period.
Those of us who are investing for the education and future of our grandchildren will take our money to the ultimate fulfillment. For those of us like me that serve on boards and investment committees of large tax-exempt groups that are responsible for universities and hospitals, the time horizons are even longer. Think about granting tenure to a forty year old professor who could be teaching for forty or more years voluntarily and an administration without an easy ability to either improve the quality of the teaching or cutting the expenditures. As far as hospitals are concerned, the outer skins of the buildings are likely to hold up for fifty to one hundred years, that is if they weren't built to federal government specifications and by low-bid contractors. However, with the marches of science and regulations many if not all of the physical plants will have to be reworked rather frequently due to perceived obsolescence.
Faulty starting points of too many LTIs
Too often we become captives of both history and the headlines of the day. Any study of past investment mistakes shows that over-confidence in our wisdom and our ability to foretell the future leads to disastrous results. I have learned through meetings with existing and potential investment managers and investment consultants that many confuse the difference between a book report and a book review. The report form abbreviates the history of their investments both statistically and thematically. A review has to do with the ability of the managers to successfully negotiate the future, or more importantly futures. I am in the continuous process of meeting with existing managers that we use and candidates for future use. To the extent that the portfolio managers and their chief investment officers (CIOs) think deeply about the future or futures, I will be probing them with some of the questions shown below and other items they or I think are important. In addition, I ask the readers of this post to react to these queries publicly or privately.
For the sake of the future, "Are profit margins too high?"
This is not a mirrored concern of my good friend Byron Wien and others that are worried that margins will surprise many by coming down in the second half of the year. My concern is different and perhaps deeper. As an entrepreneur I know that profit margins are not just a result, but to some extent are the outcomes of a very important series of operating asset allocations. Final operating margins are the consequence of a series of simultaneous equations between personnel management, development spending, foreign exchange management, balance sheet concerns and the mix of interest received and paid. Often margins are the beneficiaries of past acquisitions bringing the acquired margins up to the level of the new corporate parent. The simple statistic of profit margin does not reveal enough about its present and future composition for wise investors to properly evaluate the investment's long-term attractiveness.
Why can margins be too high?
I am not a socialist, but I raise the question, “As a society, outside of government, are we paying too little to employees?”
Because
of the prior demands of individuals and organized labor, plus government
intervention, we have encouraged the substitution of technology and to
a lesser extent foreign workers, for domestic workers. My concerns are two. The
first concern is the actual and implied replacement of domestic workers. One example is that we are
not getting enough useful new ideas from our senior and professional staffs.
There are untold numbers of instances where a relatively low paid worker on the
factory floor or in the mail room recognized something of value to
the process that was missed by the executives.
The
second concern comes from Henry Ford, certainly no radical labor leader. Ford raised
wages to an unheard of $5 per day. The history books record that his decision
to raise his workers' pay was so they could afford to buy the increasingly mass produced
Model T automobile. The
growth of high corporate revenues needs strong consumer demand.
Currently one of the concerns of investors is that while earnings progress is surprisingly good, domestically produced revenues are flat with the gains attributed to record profit margins. The news from the job front is at best misleading. While the number of new hires is marginally good, the quality of the jobs being filled is at lower levels of pay and satisfaction. Two of the indicators to watch are short-term sales in stores that cater to the middle class and the purchase of new homes.
Will the current wave of M&A lead to tears?
As pointed out by London's respected Marathon Asset Management, one of the reasons for the good margins has been bringing an acquired company's margins up to the new parent's levels. However this is a one time occurrence accomplished by tighter financial management and bigger discounts from bulkier corporate buying.
Currently one of the concerns of investors is that while earnings progress is surprisingly good, domestically produced revenues are flat with the gains attributed to record profit margins. The news from the job front is at best misleading. While the number of new hires is marginally good, the quality of the jobs being filled is at lower levels of pay and satisfaction. Two of the indicators to watch are short-term sales in stores that cater to the middle class and the purchase of new homes.
Will the current wave of M&A lead to tears?
As pointed out by London's respected Marathon Asset Management, one of the reasons for the good margins has been bringing an acquired company's margins up to the new parent's levels. However this is a one time occurrence accomplished by tighter financial management and bigger discounts from bulkier corporate buying.
However,
there are longer-term negative impacts of these deals. Often the senior management
of the acquired company is locked into the acquirer as an indentured servant
for a specified period of years. After their Liberation Day most of the original
people are gone including, perhaps those at above-scale wages. At this very
point it will become clear whether the combined company has the breadth of
management needed to make this work out well in the long-term. One of the
historic problems for companies like General Electric is the belief that a good
manager can manage anything well. In a more complex world it doesn’t happen all
the time. Rarely do we see the practice that I followed with some tiny
acquisitions: while I liked the products the acquired firm produced, what I
really wanted was the new management to join us and play a bigger role in the
overall growth of the firm. This is not happening today.
The big risk for the acquirers is that not only do the former senior managers leave the "Mother Ship" but they bring along with them or attract the bright young and entrepreneurial people that will develop the new leading edge competition. As a partial answer to these concerns I believe, along with others, that we will see more spin-outs or strategic sales. To accomplish this well and to keep the loyalty of the former parent company's workers will require skills only a few firms have.
Are you prepared for the next bubble?
In our economy we normally don't fix the inflating force that created the bubble, we just remove the flow of the assets that created the bubble. But the assets go somewhere. Most of the time investors still search for above-normal yields and because of their confidence in their own selection skills or those of their managers, dealers or brokers, they remain speculative. We are at the point of looking at mutual fund flows worldwide to suggest that the High Yield Bond fund bubble is deflating. Where is this money going to go? Wherever it goes eventually, it will likely prove to be disruptive.
What to do?
Try to look to the next visible time horizon and beyond to what may be large mistakes that in some future time periods can be corrected. Do not have too much confidence in the correctness of your present, firmly held investment beliefs. As they say, many roads to Rome (investment success). One should be on multiple routes, the more the better.
Please share your thoughts.
The big risk for the acquirers is that not only do the former senior managers leave the "Mother Ship" but they bring along with them or attract the bright young and entrepreneurial people that will develop the new leading edge competition. As a partial answer to these concerns I believe, along with others, that we will see more spin-outs or strategic sales. To accomplish this well and to keep the loyalty of the former parent company's workers will require skills only a few firms have.
Are you prepared for the next bubble?
In our economy we normally don't fix the inflating force that created the bubble, we just remove the flow of the assets that created the bubble. But the assets go somewhere. Most of the time investors still search for above-normal yields and because of their confidence in their own selection skills or those of their managers, dealers or brokers, they remain speculative. We are at the point of looking at mutual fund flows worldwide to suggest that the High Yield Bond fund bubble is deflating. Where is this money going to go? Wherever it goes eventually, it will likely prove to be disruptive.
What to do?
Try to look to the next visible time horizon and beyond to what may be large mistakes that in some future time periods can be corrected. Do not have too much confidence in the correctness of your present, firmly held investment beliefs. As they say, many roads to Rome (investment success). One should be on multiple routes, the more the better.
Please share your thoughts.
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