Tuesday, November 10, 2015

Corporate Hocus-Pocus

Warren Buffett, earlier this year in his 2014 Berkshire Hathaway (BRKa) special letter*, offered the following perspective on conglomerates:

"Berkshire is now a sprawling conglomerate, constantly trying to sprawl further.

Conglomerates, it should be acknowledged, have a terrible reputation with investors. And they richly deserve it. Let me first explain why they are in the doghouse, and then I will go on to describe why the conglomerate form brings huge and enduring advantages to Berkshire.

Since I entered the business world, conglomerates have enjoyed several periods of extreme popularity, the silliest of which occurred in the late 1960s. The drill for conglomerate CEOs then was simple: By personality, promotion or dubious accounting – and often by all three – these managers drove a fledgling conglomerate's stock to, say, 20 times earnings and then issued shares as fast as possible to acquire another business selling at ten-or-so times earnings. They immediately applied 'pooling' accounting to the acquisition, which – with not a dime's worth of change in the underlying businesses – automatically increased per-share earnings, and used the rise as proof of managerial genius. They next explained to investors that this sort of talent justified the maintenance, or even the enhancement, of the acquirer's p/e multiple. And, finally, they promised to endlessly repeat this procedure and thereby create ever-increasing per-share earnings.

Wall Street's love affair with this hocus-pocus intensified as the 1960s rolled by. The Street's denizens are always ready to suspend disbelief when dubious maneuvers are used to manufacture rising per-share earnings, particularly if these acrobatics produce mergers that generate huge fees for investment bankers. Auditors willingly sprinkled their holy water on the conglomerates' accounting and sometimes even made suggestions as to how to further juice the numbers."

Why does this sort behavior happen in the first place? According to Buffett it's because, at least for some, "gushers of easy money washed away ethical sensitivities."

Buffett on Bold & Imaginative Accounting

Keep in mind that these earnings gains on a per share basis arose from "exploiting p/e differences" instead of any real value creation. Well, it's the quality of earnings increases over a long time horizon that should be the focus of investors.
(Speculators will no doubt look at this somewhat -- or, in fact, a whole lot -- differently.)

Efforts to inflate per-share earnings will be seen for what they are in the long run and valued accordingly. Those who get caught up in such things are exposed to more risk of permanent loss than they might otherwise realize.

The way that some choose to mostly ignore stock compensation expense seems a relevant example.

Learning how to separate the real thing from the questionable is an essential part of the investment process.

"The resulting firestorm of merger activity was fanned by an adoring press. Companies such as ITT, Litton Industries, Gulf & Western, and LTV were lionized, and their CEOs became celebrities. (These once-famous conglomerates are now long gone. As Yogi Berra said, 'Every Napoleon meets his Watergate.')"

Charlie Munger, earlier this year and even more recently, has compared one particular public company to ITT.

Here's how this Fortune article described ITT:

"Over a period of nine years, Harold Geneen used his company [ITT]...to make more than 350 acquisitions in over 80 countries around the world. Sales exploded from $765 million in 1961 to over $17 billion in 1970, before the wheels started to come off. The empire was eventually revealed to be little more than a giant accounting trick that covered up the losses from one acquisition with the paper profits of the next one."

Munger describes it the following way:

"It wasn't moral the first time. And the second time, it's not better. And people are enthusiastic about it. I'm holding my nose."

Accounting rules will naturally change** over time, but this won't end attempts to be less than conservative (or worse) with how the numbers are presented and even, somewhat strangely, how they're interpreted by those who ought to know better.

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" - Upton Sinclair

Some of this behavior might also be explained, at least in part, by "career risk" and "the institutional imperative".

So why does the conglomerate structure work for Berkshire but not necessarily for others?

I'll cover that in a separate post and, at some point after that, look more closely at one of the conglomerates mentioned above.

Adam

Long position in BRKb established at much lower than recent market prices

Related posts:
Berkshire's Structure: Why It Works (follow-up)
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting

* This is Buffett's special letter that was written for the 50th Anniversary of Berkshire. Munger also wrote a separate letter to recognize this Golden Anniversary. These can also be found at the end of the regular letter (page 24 and 39 respectively).
** The fact that 'pooling' is no longer allowed is but one example. 
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