The Perils Of Too Much Debt

Clarence Saunders—an oft-forgotten early 20th century entrepreneur—is one of the five most important men in the history of American groceries. You could make an argument that he deserves a spot on the list of the top 100 most important businessmen of the entire 20th century.

Saunders revolutionized the grocery store business by recognizing why small-town grocery store chains kept failing.

In the early 1900s, the typical grocery store experience had similarities with visiting a pharmacy today. You would show up at the storefront, present a list of what you needed, a clerk would retrieve the items, and then you would pay the bill or pay it on credit (grocery stores would keep a ledger of amounts owing).

This made it difficult for small-town grocers to earn a profit because the number of clerks required to retrieve objects was high, the non-payment of bills by families paying groceries on credit led to delinquent accounts, and there was little opportunity for “splurge” purchasing when someone shows up with a pre-planned list.

So Saunders took the drastic action of making his Piggy Wiggly grocery stores extreme outliers in the retail space. He created the concept of self-service—that is, letting the customers enter the store and inspect the inventory for themselves to select what they want. Other grocers never did this because they thought it added a barnyard cultural flavor and created the risk of customer theft by allowing them to have unrestricted access to items that they could just stick in their pockets (and if you hired security to perform inspections, this would defeat the cost savings efforts of not having clerks fetch the items.)

Nevertheless, Saunders forged ahead by letting the customers access the inventory and watched as the typical shopping trip shot up from 23 items to 28 items. Not only was he cutting costs by lowering the employee count required to service customers, but he was also enjoying top-line growth as well by increasing the number of items that customers bought by over 20% due to the splurging that occurs when whimsical items of interest are right in front of you.

Furthermore, the early Piggy Wiggly stores accepted only cash payment, removing the delinquent accounts and debt collector department from the business model. It was an act of great simplicity—people find and buy what they want, and you only have to a have a person to process the transaction (upon which you received prompt payment.)

Now, the part of Saunders’ about the requirement of cash payment is a mixed message. That tactic worked really well in the case of small-town grocers in the 1910s, but for a contrary case study, the rise of Sears in mid-20th century America can be explained by Sears’ willingness to accept borrowers that paid on credit in installments for a few years.

I was talking to a friend recently about how there are so many things that we take for granted because they have always been there but there once a time when it was novel and fresh. Ever used the phrase “to break the ice”? That comes from Shakespeare in “Taming of the Shrew” when Tranio said: “If it be so, sir, that you are the man must stead us all, and me amongst the rest, and if you break the ice and do this feat…for our access, whose hap shall be to have her.” That was an incredibly witty way of taking the literal act of boats breaking the winter ice so that the subsequent seamen will know which way to go and using it as a term to describe a social connection. Having that phrase always be there makes you discount, but there was a point when it was a brilliant contribution to civilization.

That is how I feel about Saunders. His Piggly Wiggly stores completely changed modern retail, and advanced the civilization forward in that Piggly Wiggly stores were able to charge much lower prices to customers because Saunders and the rest of the ownership group could charge a smaller premium over the supply costs and still do well for themselves.

Within his first five years of introducing the concept, Saunders was able to branch out into over 1,000 stores across 26 U.S. states that hit the $100 million. That is an incredible success story—from a single location to an amount of money that still sounds unfathomable even using our knowledge of the dollar’s value in the 2010s as a reference point.

To enjoy the fruits of his success and brilliant concept, he began to build a million-dollar mansion for himself in the early 1920s that was affectionally dubbed “The Pink Palace.”  He should have died with an inflation-adjusted net worth of billions of dollars, and it would have been deserved based on the philosophical brilliance and execution of his idea.

But Clarence Saunders died broke. What happened to him in 1923?

One of his bankers, Theodore Johnson of the First National Bank of Memphis, convinced him to pledge as security the real estate backing up his holdings and the Pink Palace to purchase large chunks of the 200,000 shares that he did not already own. In other words, Johnson convinced Saunders to risk that which he could not afford to lose in an effort to gain something that he did not really need.

Saunders tepidly pursued the plan, borrowing a million here and a million there, suggesting that he had some awareness of the philosophical concept that the seemingly rational course of actions in a stabilized situation is to leverage up such that the characterization of your asset is no longer as stable as when you had just begun.

Johnson was right that Piggly Wiggly was an incredibly stable asset. It had over a thousand stores dominating their markets and generating a profit, and new stores in the offing. The lack of leverage on the balance sheet did mean “underperformance” relative to potential given how stable the core business was performing.

But once Saunders began to borrow and pledge all of the corporate and his personal real estate assets as collateral for the loan, the characterization changed. Leveraging up made sense when viewed from before the transaction, but once the transaction was complete, the asset was no longer the risk-free cash cow because it had been leveraged. That’s the tricky part of debt—it looks really rational before you take on, but once it is there, the calculation is no longer the same.

Saunders first encountered trouble when his New York locations started to see their profits plummet. As a secondary idea, Saunders began to consolidate suppliers and give customers very few choices in terms of which brand to purchase or any specifics about the goods (See Henry Ford’s quote: “You can buy any color Ford car you’d like as long as it’s black”). Saunders’ theory was that this would enable him to purchase in bulk and lower costs even more, but it proved dramatically unpopular.

As the New York stores faltered, the Wall Street investors in close proximity to see the failure began to short the stock in an effort to profit from an expectation that the stock price would fall. This enraged Saunders, and he took it as a personal attack. There were 200,000 shares that he didn’t own, and he leveraged up to purchase all of them. When the New York Board of Governors learned of his plans, they banned the stock from trading on the exchange and invoked their plenary powers to give the short sellers time to respond. Saunders didn’t expect this, couldn’t cover the interest on his debt that he was borrowing from the bank, and had to forfeit the Pink Palace in a sale to the City of Memphis (where it functions as a publicly-owned museum to this day.)

None of these debt woes should have affected Saunders. He should have pulled some money out of Piggly Wiggly and built up other income streams, like Sam Walton did with Arvest Bank and the purchase of Little Rock newspapers. At a minimum, he should have kept his grocery stores loaded with cash and refused to leverage them. If he wanted to buy more, he should have done it slowly through the profits that flowed his way. He was already in control and building new stores at a breakneck speed. He did not need to introduce an element of risk to his plans.

This is a criticism I have with the way that the current crop of MBA graduates are being taught to think about debt. The economic textbook wisdom is that borrowing makes sense when your projected return exceeds the cost of the debt. Managers make their projections, and then treat those calculations as etched in reality even though they are estimates.

This is why you’re seeing more and more large corporate bankruptcies. In 1987, there was only 15 bankruptcies in the United States that involved businesses valued at over $100 million on an inflation-adjusted basis. By 2017, there were over 100 of them. Yes, competition is more brutal, but that is not fully explanatory. It’s not just businesses burdened by pension payments that built up over the decades and experienced a faltering business model that are working their way through the bankruptcy courts. You are seeing businesses that load up on debt, repurchase stock, and then collapse during the next recession (heck, that is why Sonic the hamburger joint nearly collapsed during The Great Recession).

When there is no debt on the balance sheet, or a very manageable debt level, and there are predictable cash flows, it sounds like the rational course of conduct to add debt and leverage to the balance sheet. But once the leverage is there, the asset is now riskier because there are required payments that must be made and automatically vacuum up a portion of the profits.

I suspect these kinds of case studies are why Warren Buffett refused to borrow money to purchase Berkshire stock during his fight with Seabury Stanton. Even though he was giving in to his revenge impulse, he wouldn’t shut off the part of his brain that always reminded him that leverage is the surest way that already successful businessmen fail. Clarence Saunders contributed a lot to the evolution of grocery stores in America, and it tried to pay him back commensurately, but he had to have more.


Originally posted 2018-07-27 01:20:43.

Like this general content? Join The Conservative Income Investor on Patreon for discussion of specific stocks!