The Great American (Ponzi) Scheme – Capital Intensive Businesses And Diminishing Returns

“A growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years.” – Warren Buffett

(I will do this experiment after my finals and post an article to follow.)

Above was a small discussion from Warren Buffett in one of his annual letters to shareholders about the pitfalls of investing in yesterday’s winners. This article is based from the small excerpt from John Train’s“The Money Masters” under the first chapter on Warren Buffett, the final entry being “The Great American Jam Tomorrow Ponzi Scheme.”

Buffet explained in 1980 that a large portion of American enterprises are at risk and investors should stay clear of them, based on the massive investment that they will have to make. The cause of the large investments these companies must make is regulation, competition, rising labor costs, globalization, pursuit of productivity improvements, higher obsolescence rates than depreciation, etc.

Essentially, these companies need endless amounts of (net) new cash, and of course, this (net) new cash offers interest and dividend payments in the mean time to induce investors to continually partake in the illusory party. Dividends are continually increased to push equity prices higher then further secondary offers commence to pay for additional capex and dividend liabilities, diluting shareholders and ending in most cases with an eventual dividend cut. Other wise investors will continually stake money in mandatory rights offerings to continue to own the same percentage of the company. The chances investors ever actually see their (full) capital returned is slim, let alone with a satisfactory return, either due to dilution, bankruptcy, or take-overs below investors average costs.

Buffett described this process in a simple phrase, “Jam yesterday and jam tomorrow, but never jam today.” Companies that continually issue bonds or offer equity, while paying a dividend or are simply net users of cash (after honest depreciation plus competitive capex) and never actually provide net cash over long periods of time, could be classified as a Ponzi scheme. These companies have an obsolescence rate that is faster than their allowable depreciation, thus creating bottomless capex pits.

Buffett uses an example of Ford Motor Company (in 1980): “Ford doesn’t ordinarily pay enough dividends to give its own shareholders after taxes, the equivalent of 100,000 cars a year out of the 6-odd million that it makes. All that money, that huge plant, those many generations, and still the impact of higher costs, taxes and foreign competition mean that the owners can’t even claim 2% of the output.”

These companies need to retain earnings continually to pay for improvements and new plants, machinery, equipment, etc. Like most of us would know and agree, compounding capital or interest can work in the opposite direction, although asymmetrically (meaning a 50% loss must be made up by a 100% gain).

The key here is increasing your purchasing power in real terms, not absolute values. Buffett provided another three examples of capital-intensive businesses in “heavy” industries. The examples were AT&T, American Airlines and General Motors (ironically GM he now owns).

AT&T can be classified in the “ratchet up” dividend-equity offering strategy outlined above, coupled with large bond offering to finance capex, acquisitions and dividends. General Motors is a similar example to the Ford example provided; scroll up for a refresher.

In regard to American Airlines, Buffett mentioned it only turns its capital (including leased equipment and facilities) once a year. He said on that basis it would need to realize close to 20% pre-tax profit margins on sales in order to net 10% if financed by equity capital. This would put American Airlines at the time at the top of the industry for pre-tax profit margins. (It has gone bankrupt in the mean time and is planning to to exit after a recent federal judge approval).

Buffett when talking to an executive of a capital-intensive business (anonymous) asked, “Why don’t you buy back your own stock? If you like to buy new facilities at one hundred cents on the dollar, why not buy the ones you know best and were responsible for creating twenty-five cents on the dollar?” 

The executive responded, “We should.” 
Buffett: “Well?”
Executive: “That’s not what we’re here to do.”

He didn’t buy the stock.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s