The Businesses That Run Themselves

Due to neglect, I’ve built up a few hundred mailbag questions that I have not been able to address. I hope to be more ambitious in tackling them, and this is the first.

What surprises you the most about the financial commentary you see from other writers?

I am surprised at how often pundits and retail investors fail to separate the inherent nature of the enterprise itself from the people running it. For instance, almost every finance writer concludes that Michael Eisner was an extraordinary Disney CEO between 1984 and 2005. Such an opinion is informed by the 18% annual returns of Disney stock during his tenure–you needed to invest $36,000 on the day he became CEO to become a millionaire by the time he resigned.

This assumes that Eisner did great things, rather than operated a business that was doing great things on autopilot. When he became CEO, it cost $15 to visit the Magic Kingdom. When it resigned, it cost almost $60. He raised prices more aggressively than his predecessors, and given that the market was willing to bear it without a significant exchange in the experience, it suggests that he was able to quadruple earnings by wringing out untapped pricing power from the creations of his predecessor.

Soda went up from $0.25 to $3. Hotel prices quintupled. Yes, Eisner did good things like buy ESPN/ABC, Miramax Films, and produce The Little Mermaid, but you also have to take into account the poor uses of capital like Disneyland Paris, the loss of Jeffrey Katzenberg to DreamWorks, the overproduction of failed initiatives related to “Who Framed Roger Rabbit?”, as well as the cultural change that prompted criticism from Roy E. Disney.

Roy E. Disney, the nephew of Walt Disney and the son of co-founder Roy O. Disney, originally brought in Eisner in 1984 because he wanted to grow Disney’s market cap. I mean what I said there: Roy E. Disney’s primary focus was not shareholder returns, or the highest-quality way to boost earnings per share, but rather, to boost the size of Disney’s valuation so that it would become too big for a corporate raider.

To get an idea for how small Disney was back then, no less than Warren Buffett himself was able to buy 5% of the overall company back in 1966. It was an $80 million company. Buffett sold the company a year later for a 50% gain (something he would later consider a mistake given the position would grow to $10 billion today and is a great reason why you shouldn’t sell something like Nike or Church & Dwight when it appears to be 30% overvalued.)

Eventually, though, Roy E. Disney lost his faith in Eisner. ABC had a long series of duds in new content in the late 1990s and early 2000s. The ambitious plans for new theme park locations and significant expansion at the existing ones had vast cost overruns and the projected revenues did not materialize.

He also became concerned with the changes in company culture, fearing that Eisner facilitated micromanagement at the studios (to ensure that movies matched his desired morals). When Disney resigned from the Board, he claimed that Eisner had turned The Walt Disney Company into a “rapacious, soulless machine.” That was Disney’s final public statement to Eisner, and he di not explain what Eisner specifically did to provoke that claim.

I mention all of this to say that the reality is different from the perceived legacy. Eisner did some things that worked out well, and did some things that did not work out so well. He benefited tremendously from the fact that Disney had a fantastic collection of intellectual property–spanning from network channels to movies to theme parks to hotels to cruise ships to toys–that also positioned him to earn a halo effect by raising the prices of legacy products.

This halo effect that benefits the executives of companies with strong moats and pricing powers turns into a horns effect when describing the leadership at businesses that lack these advantages. The aluminum and deepwater oil rig industries have seen great turnover in leadership over the past 18 months, with the Board expressing disappointment and message boards throughout the internet publicly ridiculing these now former executive members.

I am not enthusiastic about this popular reaction–it is so much easier to run a chocolate company like Hershey compared to a deepwater oil driller during a 50% decline in commodity prices. Running a chocolate company forces you to think about price hikes, packaging changes, acquisitions of other confectionary companies, national/international expansion, some new production testing, and capital return policies. In a worst case scenario, you get Irene Rosenfeld–negligible growth and a moderate dividend.

On the other hand, if you run a deepwater driller, you have to figure out what to do when Shell, BP, Exxon, Chevron, and Conoco only call you to cancel orders and the demand for your product largely evaporates because drilling for oil in remote locations no longer makes economic sense for the largest producers when oil trades in the $40s.

This information is important for two reasons. The first is moral–it prevents you from giving unearned praise to people who don’t deserve it and it also prevents you from giving unwarranted blame to people who don’t deserve it. And secondly, it also helps you focus on the relationship between natural, inherent characteristics of a business and the management team.

Take something like Huntington Ingalls Industries (HII). It was a 2011 spinoff of Northrop Grumman. Someone might look at that and see the 31% annual returns since the spinoff that has almost quadrupled the original investment in under four years and conclude that is a wise place to store long-term capital. Wrong. The shipbuilding industry is historically the worst sector of the economy–with only 3% annual returns since 1900 due to the poor returns on capital and long history of eventual bankruptcy in the sector–but currently benefits from the politically connected and savvy leadership.

Despite those 31% annual returns in four years, you would not want to own Huntington Ingalls for the next fifty years. At some point, you will most assuredly find an average executive team and the lucrative returns will not only disappear, but the company will deliver performance that is a shell of what you’d get from an S&P 500 Index Fund. If you want to praise a CEO for value-added leadership, write C. Michael Peters at Huntington Ingalls because he deserves it. At some point, though, it may be 2020, 2030, or 2040, the reversion to the mean will happen and the returns will barely pace the inflation rate.

If you’re a long-term investor, you should always prefer owning a strong oil, health-care, consumer staple, or chemical company with mediocre leadership to a materials company with outstanding leadership. Just as sub-average leadership cannot drag down a great brand forever, a great leader will not be around forever to prop up a poor economic engine. Jockey stocks should be considered niche positions with intended holding periods lasting less than ten years.

Segregating natural business characteristics from leadership teams is an indispensable technique in evaluating the competency of a particularly executive. Too many people think, “That guy delivered 12% annual returns, that other guy delivered 6% annual returns. Of course the 12% guy is better.” That may be true, but not necessarily so. You should also study how someone goes about generating those returns, and try to figure out how much is a product of industry vs. legacy vs. ingenuity. Delineating these three elements also helps you focus on the best sectors of the economy for long-term investments, as it is great to own an asset that does not require exceptional leadership in order to deliver exceptional long-term returns.