When Doing The Right Thing Doesn’t Pay Off

Some of the most outstanding businesses in the world have cut some corners in recent years. Pepsi has kept the size of Doritos bags the same, but has cut the amount of chips in each bag by a noticeable amount. Hershey has reduced the size of its candy bars, and has also reduced the amount of actual milk chocolate put into each bar. And Irene Rosenfeld, the CEO at Mondelez, is reducing the brand equity of Cadbury Eggs by removing all dairy milk from the product and reducing the serving count from six to five.

Amidst all of this is the quirkiest large company in America: Tootsie Roll. The Gordon family has controlled 45% of the company’s voting stock for most of the corporation’s history, with the recent husband-wife duo running the company since 1962. Ellen Gordon inherited the business from her father, and she appointed her husband CEO in 1962. Melvin died at the age of 95 in January (he was the only CEO in America that was older and had a longer tenure at the top than Warren Buffett.) And now Ellen, who inherited the company, has finally assumed the CEO position at the tender age of 82.

I described the company as quirky because it re-used the same annual report formatting each year, only updating it to reflect the numbers. It issued the absolute minimum quarterly information to comply with SEC regulations, and following the annual report’s formatting, only updated the numbers with each issue. It issued a 3% stock split each year that is sometimes had been incorrectly called a dividend. Every year, the company would increase your share count by 3%, but you would also own three percent less of the business overall so the beneficial effect was zero. Also, the company banned investors and customers alike from touring the candy-making facilities.

From a moral standpoint, there was much to love about the Tootsie Roll brand. Melvin and Ellen were married 65 years, and everyone who met them indicated they remained deeply in love as they spent the 20th century working side by side to produce chocolate. They made Tootsie Rolls, Junior Mints, Dots, and Blow Pops, among many others. They worked in a happy business–they didn’t have to spend their lives delivering foreclosure notices; they gave people leisure treats. They have been uncompromising in their ethics, refusing to cut ingredient costs like many of their competitors did when the candy market stalled.

This has inspired great brand loyalty among the people that followed the company, but it has not been a great formula for investors. Other than the famous 1970s owl ad, the company maintained a small presence in candy advertising, following the perhaps outdated notion that people should simply discover the products and become lifelong fans. Melvin Gordon was slow to make acquisitions if he found anything questionable, and while this ensured that he would never become a riches-to-rags story, it placed a lid on the company’s growth potential. And a non urgent desire to expand the core business carved the path for stagnation, even though the quality of Tootsie Roll’s ingredients eclipsed all of Tootsie Roll’s peers in the cheap chocolate market.

Between 1999 and 2015, Tootsie Roll doubled its sales per share from $5 to almost $10. Usually, this converts into decent annual earnings per share growth in the 6-7% range. Couple it with a dividend, and there’s usually nothing to complain about. But that’s not what happened at Tootsie Roll. Earnings per share of $0.91 in 1999 gave way to earnings per share of $1.05 (expected) in 2015). The actual dividend yield is only 1%. The company sits on a fat stack of cash–it makes $64 million in profit per year, and only carries $8 million in debt while sitting on $138 million in cash.

It has only delivered 2% returns since 1999, turning $10,000 into $12,750 over the past sixteen years. That figure actually overstates the case, as Tootsie Roll has been trading at over 29x earnings since Melvin Gordon’s death due to a market expectation that Hershey, Lindt, Nestle, Kraft, or some sweet treat confectioner will buy it.

Earnings have gone nowhere while sales doubled because the company built a large cash position, virtually wiped all debt from the balance sheet, and maintained quality ingredients instead of lowering costs and hoping that no one notices. These are virtues. This is a good life. Melvin and Ellen Gordon have contributed to the civilization, presumably made themselves happy, and delighted customers for decades. The only non-beneficiaries of their existence have been investors.

Normally, it is good to reach an “enough” point. Once you can pay for your home, transportation, food, and walking around money, it is commendable to have limited material desires beyond that. The problem arises, however, when expectations become mismatched: The Gordons no longer sought to create wealth because they did not need more money in their bank accounts, while owners of the enterprise presumably bought shares because they wanted to get richer.

The infrastructure for growth has been there: Tootsie Roll only pays out 30% of its profits as dividends. It could easily acquire new candy businesses, or aim for aggressive expansion of existing products into new locations. The right executive at Tootsie Roll could make growth happen.

If the mismatched incentives were the warning the bell, the proof was that Tootsie Roll was only making 9% profits on each item sold, only about as third as profitable as a typical Hershey candy bar. And sales were just trickling forward at a Sunday afternoon pace each year. Lower than usual profits, mixed with low revenue growth, acted as numerical proof of Tootsie Roll’s stagnation.

Building a great brand is important. You want repetitive buyers if you want to run a successful business, and delivering quality is the greatest way to ensure that. But that has never been the full sum of the equation. Doing all the right things to maintain the status quo can give a steady existence, but it won’t lead to strong strides in net worth. You have to expand existing products by moving into new markets, acquire new companies, or repurchase large amounts of stock like Exxon or IBM, if you want to build wealth. Tootsie Roll got everything right over the years, and acted admirable in every respect, but missed this last element, and shareholders have suffered for it.