Wednesday, October 10, 2012

Investing Lessons From the Godfather

Investors are always analyzing companies and industries, and hoping to find favorable trends within them. We applaud companies that do well and, in turn, criticize those that fail. We expect companies to be able to seek out profitable industries and invest in them while readily discarding operations in sectors that are failing.

But what if it doesn't work like that?  What if companies are stuck with an industry because this is what they have always done?

For a deeper insight let’s consider Hyman Roth in The Godfather II.  He responds to Michael Corleone’s challenge by indirectly accusing him of ordering the murder of his friend and colleague Moe Green -shot in the eye by one of Corleone’s henchman earlier- and points out that

“Someone put a bullet in his eye. No one knows who gave the order. When I heard it. I wasn’t angry…  …And I said to myself this is the business we have chosen. I didn’t ask who gave the order because it had nothing to do with business”

So there you have it. You chose a line of business. You invest and educate yourself into it. It is what you do. So be prepared for the bad times and the good, and don’t expect to change anything fundamentally, because this is the business you have chosen.

When industries fail

I’m reminded of this quite often when I come across a business that is failing or a company in trouble. It’s easy to sit back and say, "Well, they should do this or that." But in reality, fundamental change is impossible for most companies and it takes a long time -- if ever -- for it to take place. In addition, profit maximizing decisions are not always taken if they conflict with the continuation of the companies activities.

To give an example, consider the 3G license auctions given in the UK at the end of the dot-com boom. The prices were seen as inordinately high, and every commentator criticized the amount that the winners paid. But what were they supposed to do? If you are Vodafone or Orange, how an earth could you not buy a next-generation license for your customers? It may not have made immediate sense or even been the optimal decision, but as an ongoing concern, they had no option. This was the business they had chosen.

For an example of restructuring when in a challenged industry, consider the problems facing Hewlett-Packard $HPQ or Dell $DELL with intense competition amidst declining sales of PCs and notebooks. It’s easy to criticize Meg Whitman for continuing to invest in these industries and claiming that HP wants to retain market leadership, but what other options does she have? As a mature business, I’m sure its PCs and notebooks generate cash (albeit declining), and the company has substantive debt which needs repaying. HP’s flexibility is limited. Everyone hopes it can be the next IBM $IBM but in truth it took ‘Big Blue’ an awful long time to restructure away from the PC business. This is the business HP chose.

Keeping it real
It is not just about the operations of a company, but also its very brand and product that define the business. Consider Research In Motion $RIMM and the BlackBerry. Again, it’s easy to criticize an out-of-date model and eulogize over its rivals, but what is RIM supposed to do? It can’t just ditch the BlackBerry and start producing iPhone clones. The Blackberry is the business that it has chosen. I fear that attempts to start releasing models without keypads and other such developments will not work as hoped. The Blackberry has too strong a defined image.

Bash the bankers, part 3462

The final consideration here is with industries whose personnel have built up into positions of authority precisely because they had certain qualities. This argument is better described as the "people that the businesses have chosen" than the business itself. Consider banking. Year after year of everybody making the same bet on  the same structured derivatives can encourage the detritus to rise to the top.

Let me put it this way: In a uni-directional market, who is the winner? The answer is, the person who takes the most risk. This person then gets all the praise and gets promoted. The result is that the industry is populated at the top level by people who have very little real knowledge of risk.

Consider Barclays $BCS which was actually regarded as one of the best run British banks and never had to receive bailout money. What a lot of people forget is that they only achieved this by chance. The truth is it was in a bidding war with RBS in order to buy the ill fated ABN Amro. It lost. The fact that it failed meant it didn’t buy the toxic bank and it prevented Barclays from using its firepower to leverage up on other investments. Pure good luck via serendipity. Bob Diamond and company were on the board then too.

I’d argue that none of these decisions made any sense, and nor did Dick Fuld when he did all he could to stop Lehman’s receipt of government aid. What made these players act in the way that they did? Why did they make suboptimal decisions? Why?

Because this is the business they have chosen.