Tag Archives: Value Traps

Fortune 500 Extinction

Be aware of the fragility of companies no matter how powerful today.

Fortune 500 Firms in 1955 vs. 2011; 87% Are Gone.

What do the companies in these three groups have in common?

Group A. American Motors, Studebaker, Detroit Steel, Maytag and National Sugar Refining.

Group B. Boeing, Campbell Soup, Deere, IBM and Whirlpool.

Group C. Cisco, eBay, McDonald’s, Microsoft and Yahoo.

All the companies in Group A were in the Fortune 500 in 1955, but not in 2011.

All the companies in Group B were in the Fortune 500 in both 1955 and 2011.

All the companies in Group C were in the Fortune 500 in 2011, but not 1955.

Comparing the Fortune 500 companies in 1955 and 2011, there are only 67 companies that appear in both lists. In other words, only 13.4% of the Fortune 500 companies in 1955 were still on the list 56 years later in 2011, and almost 87% of the companies have either gone bankrupt, merged, gone private, or still exist but have fallen from the top Fortune 500 companies (ranked by gross revenue). Most of the companies on the list in 1955 are unrecognizable, forgotten companies today. That’s a lot of churning and creative destruction, and it’s probably safe to say that many of today’s Fortune 500 companies will be replaced by new companies in new industries over the next 56 years.

What Causes Corporate Decline According to Steve Jobs

Update: Here’s a related article from Steve Denning in Forbes, featuring some insights from Steve Jobs about what causes great companies to decline (power gradually shifts from engineers and designers to the sales staff) and how the life expectancy of firms in the Fortune 500 and S&P500 has been declining over time.

Also, the impending death of a big-box retailer, Best Buy: http://www.forbes.com/sites/larrydownes/2012/01/02/why-best-buy-is-going-out-of-business-gradually/

Peggy Noonan On Steve Jobs And Why Big Companies Die

There is an arresting moment in Walter Isaacson’s biography of Steve Jobs in which Jobs speaks at length about his philosophy of business. He’s at the end of his life and is summing things up. His mission, he says, was plain: to “build an enduring company where people were motivated to make great products.” Then he turned to the rise and fall of various businesses. He has a theory about “why decline happens” at great companies: “The company does a great job, innovates and becomes a monopoly or close to it in some field, and then the quality of the product becomes less important. The company starts valuing the great salesman, because they’re the ones who can move the needle on revenues.” So salesmen are put in charge, and product engineers and designers feel demoted: Their efforts are no longer at the white-hot center of the company’s daily life. They “turn off.” IBM [IBM] and Xerox [XRX], Jobs said, faltered in precisely this way. The salesmen who led the companies were smart and eloquent, but “they didn’t know anything about the product.” In the end this can doom a great company, because what consumers want is good products.

Don’t forget the money men

This isn’t quite the whole story. It’s not just the salesmen. It’s also the accountants and the money men who search the firm high and low to find new and ingenious ways to cut costs or even eliminate paying taxes. The activities of these people further dispirit the creators, the product engineers and designers, and also crimp the firm’s ability to add value to its customers. But because the accountants appear to be adding to the firm’s short-term profitability, as a class they are also celebrated and well-rewarded, even as their activities systematically kill the firm’s future.

In this mode, the firm is basically playing defense. Because it’s easier to milk the cash cow than to add new value, the firm not only stops playing offense: it even forgets how to play offense. The firm starts to die.

If the firm is in a quasi-monopoly position, this mode of running the company can sometimes keep on making money for extended periods of time. But basically, the firm is dying, as it continues to dispirit those doing the work and to frustrate its customers.

As the managers find it steadily more difficult to make money playing solely defense, they become progressively more desperate and start doing ever more perilous things, like looting the firm’s pension fund or cutting back on worker benefits or outsourcing production to a foreign country in ways that further destroy the firm’s ability to innovate and compete.

There is another way

What’s interesting is that Steve Jobs lived long enough to show us at Apple [AAPL], in the period 1997-2011: what would happen if the firm opted to keep playing offense and focus totally on adding value for customers? The result? The firm makes tons and tons of money. In fact, much more money than the companies that are milking their cash cows and focused on making money. Other companies like Amazon [AMZN], Salesforce [CRM] and Intuit [INTU] have demonstrated the same phenomenon and shown us that it’s something that any firm can learn. It’s not rocket science. It’s called radical management.

Fifty years ago, “milking the cash cow” could go on for many decades. What’s different today is that globalization and the shift in power in the marketplace from buyer to seller is dramatically shortening the life expectancy of firms that are merely milking their cash cows. Half a century ago, the life expectancy of a firm in the Fortune 500 was around 75 years. Now it’s less than 15 years and declining even further.

The above articles are yellow flashing lights on the longevity of competitive advantage for established companies.  Do you agree with the article’s premise?

Misery, First Solar (FSLR), Invert

Johnson spoke well when he said that life is hard enough to swallow without squeezing in the bitter rind of resentment.  Charlie Munger

“Invert, always invert,” Jacobi said. He knew that it is in the nature of things that many hard problems are best solved when they are addressed backward. –Charlie Munger

How to Guarantee Misery in Your Life

Below are tips from the great and the not-so-great on how to guarantee misery and second-rate achievement in your life.

Johnny Carson says,

  1. Ingesting chemicals in an effort to alter mood or perception;
  2. Envy, and
  3. Resentment.

John Chew pleads: Meet my Ex.    http://www.youtube.com/watch?v=i5OlolbLXvw.    Not to be watched if squeamish.

Charlie Munger intones:

  1. Be unreliable. Do not faithfully do what you have engaged to do.
  2. Learn everything you possibly can from your own experience, minimizing what you learn vicariously from the good and bad experience of others, living and dead.
  3. Go down and stay down when you get your first, second, or third severe reverse in the battle of life.
  4. Avoid thinking creatively about problems. Never invert.

First Solar

Now to put our lessons to the test…

I read the news this morning…Oh boy. –The Beatles.

This morning I read a Bloomberg story discussing First Solar’s attractive valuation following its recent selloff.  Also analysts have rekindled takeover chatter. “First Solar is still profitable,” a Kaufman analyst explains. “So you are buying the best in the industry at a discount price. Certainly for both GE and Siemens (SI), it would diversify their energy platform.” FSLR trades at 60% of book value and 5 or 6 times trailing earnings.

If the Kaufman analyst said that to me, this is exactly how I would respond. http://www.youtube.com/watch?v=6eXFxttxeaA

Why?  What is the strategic thinking you would need to do before considering this as an investment?

How could you have avoided this house of pain before the price drop?

 

http://ycharts.com/:

Subsidy Orgy Ending, First Solar’s Hangover is Just Beginning By Jeff Bailey

Ever been to a sporting event where, during a break in the action, they wheel out that clear booth, stick some poor sucker from the crowd inside, and cash is blown into the enclosure for a brief period of shameless money-grabbing?

The global boom in government subsidies to the solar panel industry went something like that, and one can see the brief and frenzied joy of that period in First Solar’s (FSLR) up-and-down stock chart, with today’s price a steep 90% or so below the peak.

The good times were good. Malaysia was handing out huge tax holidays for manufacturers, so First Solar built plants there. Germany seemed intent on covering every roof with solar panels, paid for in part by government subsidy, so First Solar sales were huge there. And not to be left out, the U.S., during its giddy economic stimulus days, offered cash grants for solar installations. Party on.

But, as with past alternative-energy orgies, the good times must come to an end. Goodbye to First Solar’s market cap of $20 billion. Jimmy Carter’s Public Utility Regulatory Policies Act of 1978, known as PURPA, led to tens of billions of dollars of alternative energy projects, including some early and costly solar. But paying above-market electricity rates to subsidize the projects became so costly that PURPA was eventually curtailed.

Poor politicians can’t help themselves. They love stuff like solar and wind, which generate manufacturing and construction jobs and makes everyone involved seem so with it. More efficient energy projects – like ones that reduce consumption – are by comparison so boring, even if they make more sense.

Last week, in announcing reduced earnings projections for 2011 and 2012, First Solar’s CEO Mike Ahearn said, “we are recalibrating our business to focus on building and serving sustainable markets rather than pursuing subsidized markets.” Investors can count on thinner margins and all the hassles and expenses that go with building and operating huge energy projects. And solar remains a relatively expensive way to make power. Unless the brent crude oil price chart goes to $200 a barrel.

In the meantime, the stock is bound to look super cheap by some measures. A trailing PE of 5, of course, suggests some big adjustments ahead to the E.

But it won’t be until 2014, Ahearn said in a statement, that First Solar’s will “earn substantially all” of its revenues from non-subsidized markets. So the results until then are nothing to make long-term bets on. The last of the party is still winding down. End.

Thoughts on First Solar and Competitive Advantage

OK, I am not saying First Solar is not a buy at any price, but what did the Wall Street “analysts” not analyze.

Studying competitive advantage will help us as much in avoiding a house of pain as in finding profitable investments.

Strategic Logic and Kodak Part 2

Happy Thanksgiving to all

Part 2: Kodak Case Study

The book that discusses this case: http://www.amazon.com/Strategic-Logic-J-Carlos-Jarillo/dp/1403912599/ref=sr_1_1?ie=UTF8&qid=1322071768&sr=8-1

Most new technologies do not create a new business, but rather a substitute for the old way of doing things. Thus, the strategic impact of a new technology will depend on how it affects the market imperfections that protected the older way of doing things. And this impact can be important. Take the case of photography, which turned to digital. You do not have to be a genius (written in 2003) to realize that the traditional business of Kodak is in danger, since every time someone buys a digital photographic camera, he or she is renouncing the future purchase of photographic paper and the products necessary for development, products on which Kodak has a high margin supported by its patents and economies of scale. There are only two important competitors in the world, Kodak and Fuji, along with a few secondary actors.

Facing this ‘announced death’ of its main business by the invasion of a new technology, Kodak seems to have a straightforward strategic solution: enter into digital photography. Kodak has been investing the important cash flow produced by its traditional operations in the new digital technologies. However, profits are not arriving and never will. The reason is that the competitive structure of traditional (chemical) photography and that of digital photography (electronic) are very different, the second being much less attractive than the first.

Traditional photography is based on a fairly specific chemical technology, on which Kodak has an important number of patents and specialized knowledge, accumulated over more than 100 years. Moreover, not only research but also most production processes are subject to important economies of scale. In addition, Kodak’s brand, advertised for a century, and its worldwide distribution reach are two more barriers that protect the company’s profits. A further positive for the manufacturers is that the price of the cameras is relatively unimportant compared with that of the consumables, such as photographic paper and developing products. Each person who buys a camera, no matter how inexpensive, ends up leaving a lot of money in Kodak’s till. For all these reasons, the business has traditionally been very profitable, with very little competition. Kodak has been able to push the rest (Agfa, Ilford) that did not have its competitive advantages from the market.  The only exception has been Fuji, which shares the market with Kodak.

This competitive structure, however, has nothing to do with the business of digital photography. To start with, there are no significant consumables: digital photos are taken with a digital camera, which does not use rolls of film, and are seen on the computer screen, without consuming film. Some, perhaps, are printed on the printer, on paper that is more normal than photographic paper and is not protected by entry barriers.

The technology of the cameras is also different, based on electronic light sensors, produced by several companies: all those that have significant capability in photo-electronics can manufacture them, and there are many. Finally, because we are dealing with a digital product, company brands such as Sony, Panasonic, HP and so on come into play, as they have credibility with consumers in this area. In short, we find a business that will be structurally less profitable than that of traditional photography, since its entry barriers are lower and the degree of competition, logically, is higher.

That is why Kodak’s effort to transform itself into a digital photography company is headed for failure. Even if it succeeds, it will find that the business is not as profitable as the traditional one. And there is not much that it can do about it: The shift from chemistry to electronics is a technological change that destroys the profitability of the traditional photography business, just as the microcomputer destroyed the profitability of large computers. If IBM has become profitable today, it is not by selling PCs, but by doing other different activities. It is a question of accepting strategic logic: the profitability of a company depends in the first place on the possibilities of singularization[1] that exist in its business, and if these change to become higher or lower, then profitability will change to become better or worse.


[1] Singularization means that the company can charge a higher price or produce at a lower cost or some combination thereof than its competitors or potential entrants.

Discussion of Strategic Logic (Kodak) Part 1

Part 1

Remember the cardinal rule of market analysis and investing: Those that know don’t say and those that don’t know have the floor to themselves.

You won’t find any great market or investment tips here.  What we can do is learn investment principles, strategic logic, and tools and techniques to become better investors. 99.999% percent of your success will be in applying your own thinking to the opportunities in front of you.

Strategic Logic

Studying strategic logic will be an important part of building a mental model for investment success.

I will discuss the Kodak case from here: http://csinvesting.org/2011/11/22/industry-analysis-kodak-strategic-logic-quiz/

I chose Kodak’s demise and Bill Miller’s loss to highlight several points.  Don’t follow market mavens off a cliff, make your own mistakes. You can’t lose when investing—either you make money or you learn. But to learn you must think systematically about your process, record your investments and think about your successes and mistakes.  Secondly, unless you have mental models (thanks Mr. Munger) to understand reality, you will become lost.  Mr. Miller and his team of 10 analysts including Michael Mauboussin might have been caught up in a turnaround story, the personality of a new CEO, the iconic brand name of Kodak or a plunging stock price—I don’t know—but they never asked a simple question—what competitive advantage would Kodak have in its new endeavor?

Let’s take a break to assess what is “Strategic Logic” or analysis of competitive advantages.

Strategic analysis should begin with two key questions: in the market in which the firm currently competes or plans to enter, do any competitive advantages actually exist? And if they do, what kind of advantages are they?

There are only three kinds of genuine competitive advantage:

Supply. These are strictly cost advantages that allow a company to produce and deliver its products or services more cheaply than its competitors. Sometimes the lower costs stem from privileged access to crucial inputs, like aluminum or early recoverable oil deposits (Saudi Arabia). More frequently, cost advantages are due to proprietary technology that is protected by patents (Pharmaceuticals) or by experience—know how—or some combination of both.

Demand. Some companies have access to market demand that their competitors cannot march (Ebay’s network effects). This access is not simply a matter of product differentiation or branding, since competitors may be equally able to differentiate or brand their products. These demand advantages arise because of customer captivity that is based on habit on the costs of switching, or on the difficulties and expenses of searching for a substitute provider.

Economies of scale. If costs per unit decline as volume increases, because fixed costs make up a large share of total costs, then even with the same basic technology, an incumbent firm operating at large-scale will enjoy lower costs than its competitors.

Beyond these three basic sources of competitive advantage, government protection or, in financial markets, superior access to information may also be competitive advantages, but these tend to apply to relatively few and specific situations. The economic forces behind all three primary sources of competitive advantage are most likely to be present in markets that are local either geographically or in product space. Pepsi loyalists have no particular attachment to Frito-Lay salty snacks, any more than Coke drinkers prefer movies from Columbia Studios when that was owned by Coca-Cola. Nebraska Furniture Mart, the store Warren Buffett bought for Berkshire Hathaway one afternoon, is a dominant player in Omaha and its hinterland, more powerful there than Ethan Allen or other large national furniture retailers.

Most companies that manage to grow and still achieve a high level of profitability do it in one of three ways. They replicate their local advantages in multiple markets, like Coca-Cola. They continue to focus within their product space as that space itself becomes larger, like Intel. Or, like Wal-Mart and Microsoft, they gradually expand their activities outward from the edges of their dominant market positions. (Source: Competition Demystified by Bruce Greenwald)

Think simply about competitive advantages. Morningstar categorizes economic moats in five ways.

Efficient Scale: when a company is effectively serving a limited market, rivals may have no incentive to enter. Some businesses are simply natural monopolies. This classification also applies to rational oligopolies. Think International Speedway for NASCAR races (geographic) or WD-40 in product space.

Network Effect: The value of a network is correlated to the number of connections. Large networks are most attractive for users, and it may be nearly impossible for upstarts to attain critical mass (Chicago Mercantile Exchange or CME).

Cost Advantage: Companies that thrive on being the low-cost provider in a commodity industry can offer lower prices to customers and still make a profit (Compass Minerals or Vulcan Materials). These companies create difficulty for higher-cost competitors.

Intangible Assets: Some companies have an advantage over competitors because of unique nonphysical assets such as intellectual property rights (patents, trademarks, and copyrights), government approvals, or brand names.

Switching Costs: If a company sells products that customers can’t get elsewhere—at least not easily—it has high customer switching costs. This creates a situation in which customers are willing to pay higher prices for products because of convenience.

Industry Analysis & Kodak Strategic Logic Quiz

Industry Analysis on Housing

This a report on the US housing market. Whether you agree with the author’s assumptions or not, he carefully lays out his thesis. Also, his research shows the difficulty in investing in cyclical industries. The future is unknown, but if you can find a skewed risk reward opportunity then pursue it.

http://www.scribd.com/doc/64974231/Anon-Housing-Thesis-09-12-2011

Kodak Case Study in Strategic Logic

Value-Line on Kodak: http://www.scribd.com/doc/73498449/EK-VL. Note the high returns on capital pre-2000.

50-Yr. Chart: http://www.scribd.com/doc/73498399/50-Yr-Kodak-SRC Note how the stock price of Kodak (EK) begins to underperform the stock market back in 1973/74. Back then (1972) the digital camera was invented. Coincidence or every picture tells a story doesn’t it? (Rod Stewart).

The history of the digital camera: http://inventors.about.com/library/inventors/bldigitalcamera.htm

Digital imaging also had another government use at the time that being spy satellites. Government use of digital technology helped advance the science of digital imaging, however, the private sector also made significant contributions. Texas Instruments patented a film-less electronic camera in 1972, the first to do so. In August, 1981, Sony released the Sony Mavica electronic still camera, the camera which was the first commercial electronic camera. Images were recorded onto a mini disc and then put into a video reader that was connected to a television monitor or color printer. However, the early Mavica cannot be considered a true digital camera even though it started the digital camera revolution. It was a video camera that took video freeze-frames.

Bill Miller Loses on Kodak

Bill Miller bought Kodak near $60 and then many years later sold at $1.  He said to a reporter that Kodak was his biggest mistake. He underestimated the need for a cultural change to turn the company around.  Do YOU agree with his assessment of his mistake?  Not to pick on Mr. Miller, but using strategic logic what questions would you ask if Kodak was transitioning from film photography to Digital?  What might you do if you were the CEO?

http://blogs.wsj.com/deals/2011/11/10/bill-miller-is-done-losing-money-on-kodak/

In 2002, Fortune described the quandry Kodak faced in this article:  http://money.cnn.com/magazines/fortune/fortune_archive/2002/02/04/317510/index.htm

Kodak: In The Noose

Andy Serwer                                                                                                             February 4, 2002

(FORTUNE Magazine) – When I was a boy, my grandfather gave me a few shares of Eastman Kodak. I never got a chance to talk to him about it, but I’m sure his thinking was, “Taking pictures is a great business. People will always take pictures, and Kodak is the big fish in that pond.” Well, for years my grandfather was right, and Kodak was a fair, though by no means stellar, stock. Now, however, it seems that only the first part of Grandpa’s axiom holds true. Everyone still takes pictures, but increasingly Kodak isn’t the big fish in the photography business.

Despite all of Kodak’s best efforts, this grand old American brand could very well go the way of Wang and Xerox. Which is to say the company may be hanging around for years, but for all intents and purposes, it’ll just be twisting slowly in the wind.

EK is under siege. On one side, Fuji and others are chipping away at Kodak’s very profitable consumer film business. On the other, the digital image revolution (i.e. digital photography) is hitting critical mass. Yes, Kodak is a big player in that arena, but even if it succeeds there–which is far from clear–that’s a much less profitable business than those little yellow boxes.

Take a look at the numbers. In 1991, Kodak had $19.4 billion in sales. Last year, it’s expected to have done just a bit over $13 billion. And while net income hit close to $1.4 billion in 2000, that’s about what it earned in 1988. The company has recorded “nonrecurring” losses in ten of the past 12 years. Kodak’s dividend is now $1.80 per share, but some analysts don’t think the company will earn that this year. The stock, which hit $94 in 1997, now trades for $27. (How long, you might ask, before the good people at Dow Jones do what they did to Woolworth, Bethlehem Steel, and Union Carbide, and throw EK off the DJIA?)

But there is an even more disturbing figure for EK shareholders: Sales of digital cameras climbed an estimated 30% last year, to 5.5 million units. Now, Kodak makes digital cameras–in fact, it recently became the market share leader. But (1) Kodak’s digital camera business isn’t profitable, (2) every time someone buys a digital camera he is no longer a customer of the company’s high-margin film business, and (3) to succeed, Kodak must compete with the likes of Sony and Canon.

Kodak says it’s hurting because of the recession and the slump in travel since Sept. 11. (“Why then,” asks one short-seller, “is its medical imaging business also slumping?”) As for digital photography, the company says that it’s not only selling cameras but also high-quality paper and other digital photo-finishing services. Again, though, margins there are nothing like those in film. The other problem with digital photography is that consumers seem to print far fewer images. Why bother? You just store ‘em on a disk or PC and print out the few you want when you want ‘em.

Management at Kodak has long been considered–to quote one knowledgeable Wall Street source–”entrenched, inbred, and unresponsive.” (And one key outsider, COO Patricia Russo, just left to head up Lucent.) I doubt, however, that any manager could “turn around” Kodak. What’s happening doesn’t lend itself to a restructuring. To exaggerate only slightly, we are talking buggy whips here. Film for Kodak is somewhat like long distance for AT&T: a mature, still profitable business that’s very much in decline. One thing to do would be to take Kodak’s film operation and turn it into some sort of master trust that pays out cash to shareholders. But that would probably require a level of fortitude that only an outside-raider type like Carl Icahn possesses.

Sure, film will be around for years, but let’s be real: Digital cameras are totally changing how we take pictures. Here’s a story: Friend of mine told me about a woman who mostly uses a digital camera. One day she had her old SLR instead. Her daughter looked in the back of the camera after a shot and asked Mommy where the picture was. “This camera doesn’t let you see the picture,” Mom said. “Then why are we using it?” the kid asked. Get the picture?

You answer should be no more than a few sentences.  Bill Miller is an intelligent, well-read investor but he failed to think strategically (yes, easy to point fingers with hindsight bias).  But you can take the same analysis of entering the digital photography market and apply it to investing in Salesforce, Inc. (CRM) today. If you were to invest in CRM, what questions must you ask?

If you have trouble with this case, I have started a training camp to teach strategic logic. Watch a clip of a recent training day: http://www.youtube.com/watch?v=6eXFxttxeaA

Case Study: Berkshire Hathaway–Avoiding Value Traps

A contributor, Sid Berger, generously provided us with a concise case study. Thank you Sid.

Berkshire Hathaway, Inc. Case Study – Avoiding Value Traps

“All I want to know is where I’m going to die so I’ll never go there.” – Charlie Munger

This article is the first in a series of case studies highlighting mistakes by famous value investors. This concept was unashamedly stolen from Mohnish Pabrai. See here for the article http://www.gurufocus.com/news/137071/mohnish-pabrai–his-project-to-learn-from-other-successful-investors-includes-comments-on-dell-and-aig.

In 1962, Warren Buffet came across a struggling textile manufacturer named Berkshire Hathaway. By any measure, the company was cheap. He bought shares from 1962-1965 at an average price of $14.86. This price was 22% below its December 31, 1965 net working capital of $19 per share.

It looked like a classic Grahamian purchase of a company for less than liquidation value. Buffett recognized that the business was unexciting but likely to generate a couple of good quarters which would give the stock price a temporary boost. Yet, Buffett let emotion rule and held on to the business and continued to plow more money into it. He finally pulled the plug in 1985.

What was wrong with Buffet’s investment process that led him to make this mistake? Could it have been avoided?

Buffett himself did a great post-mortem analysis in his 1985 letter to shareholders http://www.berkshirehathaway.com/letters/1985.html. I will draw upon that letter here but will expand upon some of the concepts and highlight their broader applicability.

First off, the company had absolutely no moat. That is, it had no durable competitive advantages such as brand name. To paraphrase Buffet, they couldn’t charge two cents more than their competitors because consumers had to have a Berkshire lining in their suit.

Second, textiles are an industry with no or low barriers to entry. As a result, any capex was simply wasted as all market participants countered with investments of their own. Standing on its own, Berkshire was presented with investment choices that would produce great returns. But, the investments were neutralized by each of the competitors making investments of their own. As Buffet stated, such a situation is like spectators at a parade all standing on their tiptoes to catch a better view – not much is actually accomplished.

Buffet also seems to have missed or at least minimized the threat of low-cost overseas competition. There were non-US textile mills where employees were willing to work for a fraction of Berkshire’s workers. Could Buffet have seen this coming? It’s difficult for me determine as I am not an expert on the textile industry of the mid-Sixties. He does note in his 1985 letter to Berkshire Shareholders that manufacturers in the Southern part of the US were thought to have an advantage over Berkshire because of their non-unionized workforce. So, he was at least aware that labor costs could be an issue.

More broadly, turnarounds seldom turn. Even the most gifted manager will have difficulty turning around a struggling company in a declining industry. As Buffet stated, “When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Buffet convinced himself that new management could turn around the Berkshire business, but the secular decline in the US textile industry was too much for anyone to defeat.

Also, if you’re producing a commodity, you better be the lowest cost producer. A low-cost structure is a powerful competitive advantage in that it enables a company to generate higher profits that it can reinvest into its business and distance itself from its competition. A low-cost structure also provides a business flexibility to use price as a weapon to take market share, weakening higher cost competitors who must match price and risk potential losses.

The Berkshire episode also contributed to Buffet’s move away from anchoring valuations on the balance sheet. For one thing, appraisals of liquidation value are typically unreliable. Buffet notes that Berkshire’s assets had been acquired for $13 million, had book value (after accelerated depreciation) of $866,000 and had replacement cost of $30-50 million. At auction, they fetched $163,122 gross or less than 0 net of expenses.

What checklist items does this case study produce? 1. Can the company be killed by low-cost overseas competition? 2. Is it a turnaround situation? Is this a mere blip (Amex) or an industry in secular decline (Berkshire)? Will it take large amounts of capex to turn it around? 3. Does the company have a moat? Does the industry have barriers to entry? Does the company have pricing power? 4. If the company produces a commodity, is it the low-cost producer?

Compare Berkshire with a Buffet success, See’s Candy. See’s Candy was a high quality business with durable competitive advantages that needed little capex and drowned in cash flow. Unfortunately, some companies failed to learn these lessons – even in the same industry.

See the Munsingwear case study, http://csinvesting.org/2011/09/12/case-study-munsingwear-a-test-in-thinking-strategically/. There, management continued to reinvest in the textile industry even though it was losing money on every sale.

How do these lessons apply to a company like Dell, which shows up in the portfolios of a lot of prominent value investors? In 2004, IBM sold off its PC division. At the time, the IBM CEO explained that the PC had become commodity-like and returns were unlikely to exceed IBM’s cost of capital. Is the US PC business the 2011 version of the New England textile industry in 1965?