|Home||About Us||Resources||Archive||Free Reports||Market Window|
Tuesday, December 11, 2007
Being a buyer of common stocks is a total screw job, most of the time.
Two years ago, I was trying to buy a large public publishing company. Not a share of stock – the whole company.
Its board of directors wanted to sell. My partners and I thought the deal might be interesting for strategic reasons. We'd be able to share certain back-office expenses with the new company, and we imagined we'd be able to use our new publicly traded stock to finance additional acquisitions when opportunities arose. (I knew there was a huge credit bubble when it was possible for me to arrange to borrow $90 million in pursuit of this deal...)
We traveled up to New York to meet with the management team. We all gathered in a big boardroom of a major investment bank on Fifth Avenue.
There were probably a dozen bankers and lawyers in the room. I shudder to think about how much this meeting cost... but that's the way public companies do things.
In the meeting, we proved that we had the financing required to do the deal and we showed up with the right bankers and lawyers – folks who get paid a fortune to essentially serve as real estate agents. Everyone was very nice to us. Everyone wanted to take us to dinner. (It's funny how having $90 million to spend makes you very popular in New York. Strangely, we haven't heard from anyone since the deal fell apart...)
Once we'd proven our bona fides, we got down to business. We were allowed to look at the company's books in detail and given access to the nonpublic information we needed to figure out how much cost cutting we'd be able to accomplish, which products we'd choose to keep, which ones we could shut down, etc.
Looking at the real books, we could see immediately that simply by putting this company on a private-company budget, we'd be able to cut 50% of its overhead and 50% of its employees, if not more. Out of a dozen products, only one or two made any sizeable amount of money. Getting rid of 90% of the company's products wouldn't have damaged the bottom line.
Meanwhile, the company was spending a fortune on noncore functions, like a brokerage business (!) and a bloated IT department. And that's not to mention the absurd size of the senior staff's salaries relative to the size of this business.
The company was about as well managed as a group of 5-year-olds at recess. It was a total mess.
Our bankers weren't surprised at our conclusions. They simply shrugged their shoulders. That's just the way it is... That's how public companies do business.
To some extent, the same thing – this tendency of management teams to use up every available penny of capital – is true for almost every public company.
Most of the time, the senior managers use as much of the company's profits as they can to increase the size of the company's asset base, so that their job security, the size of their bonuses, and their power in the industry will all increase. As a result, precious little capital ever makes its way down to the lowly shareholder.
Consider Oracle. This must be one of the world's best businesses. Revenue growth is consistently more than 20% per year. The company's operating margins are extremely high – more than 30%. And it makes billions and billions of dollars, year after year, in profit. Over the last three years, Oracle made more than $13.5 billion in cash from operations – after taxes.
How much did shareholders get? Almost zero.
Yes, technically, Oracle did pay $129 million in dividends. But that's less than 1% of the cash the company produced. So, where did the rest of the money go? Investments. Oracle spent $19 billion on investments in the last three years – even more money than it earned. It bought a handful of woefully overpriced software companies, investments that are very unlikely to earn the company anything resembling a satisfactory return.
On the other hand, owning these assets will keep Oracle's managers in their jobs and will probably lead to bigger paychecks, bigger staffs, and bigger bonuses.
So how do you avoid investing in wasteful public companies like Oracle or the publishing company I visited in New York? It's simple. Look for capital efficiency.
Accountants use many complicated formulas to measure capital efficiency: return on equity, returns on net tangible assets... they use even dividends as a percentage of sales.
Here's a simpler method: Look for companies that give more money to shareholders than they spend on themselves. In other words, the sum of their dividends and buybacks is greater than the sum of their capital expenditures and investments.