Rightsizing GM (Cont'd)
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*Graham and Doddsville Revisited* -- "The Intelligent Investor in
the 21st Century" (7/06/98)
*********
"The underlying principles of sound investment should not alter
from decade to decade, but the application of these principles
must be adapted to significant changes in the financial
mechanisms and climate." (Benjamin Graham)
*********
[An edited synthesis of several exchanges with readers regarding
the strike at GM follows:]
GM's Management Takes The Cake
---------------------------------------------
[Reader:] ...How much extra is spent on mgmt compensation
compared to labor compensation? Even a mere $10M would cover 125
overpaid line workers.
[GADR:] Let's take the worst case, considering the source. UAW
VP Richard Shoemaker charges that GM's "top management" has
received $22 million in cash, plus $35 million in stock options,
over the past 2 years. As bad as this is for worker (and
shareholder) morale, it pales by comparison with the dimensions
of GM's labor cost disadvantage vs. other auto makers operating in
the U.S.
A recent, cautiously optimistic, cover story in Barron's
(6/22/98) paints a stark contrast between current GM's labor
costs and those of Ford and Chrysler.
On a per vehicle basis, a Ford employee on average turns out 19%
more vehicles than an employee at GM (the comparable figure for
Chrysler was not supplied).
On a revenue basis, Ford generates 44% more revenue per employee,
and at Chrysler (which is allowed the most outsourcing), the gap
widens to 97%.
Because auto making is a low-profit-margin business, the revenues
gap implies an even greater profits gap. Ford's operating
profits per employee are almost 3 times those of GM, and
Chrysler's more than 4 times greater.
The Barron's article goes on to cite the head of the University
of Michigan's Office for the Study of Automotive Transportation
to the effect that GM must shed another 50,000 to 70,000 jobs to
be on a level labor-cost playing field with Ford. We think (at
least we hope) that this is overly pessimistic. Companies that
get their act together often turn out to need more employees than
supposed when things were at their worst.
But, regardless, GM is currently paying something on the order of
$4 billion per year too much for labor, relative to other car
makers. They could slash top management's compensation to
zero, without putting much of a dent in that figure.
GM Does Makes A Lot Of Money -- For Now
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[Reader:] Yet somehow [GADR argues that] GM has the highest free
cash flow.
Fortunately for all parties concerned, GM's North American
Operations are not the totality of GM.
GM's Latin American operations are doing well, showing that GM's
management can build desirable cars, and do so profitably.
And GM Hughes, after being turned around by Michael Armstrong
(who now heads AT&T), is also doing well.
In the current economic environment that is favorable to
financial companies, GM's finance arm, GMAC, is doing well too.
In fact, there is a sense in which the North American Operation
sells the cars at just above cost -- and makes its profit from
financing their sale. But, that's no way to run a car company --
any more than Warren Buffett would run an insurance company that
way.
GM Has To Do Well For The Full Business Cycle
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This is the U.S.'s second longest peacetime prosperity ever, so a
lot of high-overhead companies are generating positive cash
earnings now. The question remains: Do the least efficient of
these companies, like GM, once again run into the financial
shoals when the economy turns down? Unless, GM gets its costs in
line with other auto makers, the answer is likely to be "yes".
It's part of GADR's 3rd Era thesis that U.S. economic cycles have
become less cyclical, that is, economic upswings are
longer and more moderate, and downturns are shorter and less
severe. If correct, this would be more favorable for industrial
cyclicals than Mr. Market yet believes. But, industrial
cyclicals still have to have labor costs in line with their
competitors to remain in business over the long haul.
Giving Management "A Good Hard Slap"
----------------------------------------------------
[Reader:] These US companies that are so quick to move overseas,
to avoid environmental laws, or to get lower taxes, cheaper
workers, deserve a good hard slap around. None of them could
have started or built their businesses in any of these places.
(Don't get me wrong, spreading the work around is good. Some
companies abuse the process, however.)
[GADR:] Michael Moore's movie, "Roger and Me" shows GM executives
out on the golf course feigning ignorance of the fact that GM's
blue collar workers were getting evicted into the streets of
Flint at the time. It would have been very satisfying to see
Moore give each and every one of them "a good hard slap".
But, many of the while collar workers were the first to get the
slap when GM was permanently downsizing its while collar force in
the early 1990's. I'm not sure that giving the country club set
a further slap will do much to change the future lot of the blue
collar workers. Only increased economic efficiency will.
Increasing economic efficiency requires putting more productive
equipment into the hands of workers who, in turn, are more
flexible about work rules. But, that equipment is unaffordable
if its operators get paid $60,000 per year for 4-1/2 hours per
day of actual work.
And, more importantly, increasing GM's economic efficiency
requires a company-wide contract that prevents each local from,
successively, bringing the whole company to a halt over some
local issue.
Buffett Gave Salomon's Big Bats "A Good Hard Slap"
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Buffett has endeavored to maintain excellent employee relations,
throughout the Berkshire organization and its holdings. But, as
the shepherd of his shareholder's assets, he will not forever
subsidize workers at a money losing division with the surplus
generated by another. The original Berkshire Hathaway textile
company is a case on point.
On the other hand, some "workers" are more productive than
others. Buffett's management travails in the early years of his
investment in Salomon illustrate some of the perils of coming
down too hard on the compensation of the top producers.
It's something like baseball. The sky high salaries of the best
ball players are the cause of much resentment, from the
groundskeepers to the fans in the stands. But, the problem with
not paying astronomical sums to batters that hit over .300 and
pitchers that win over 20 games is that, in this age of free
agency, they have a tendency to take their talent (and their ego)
to a team that will.
There is no doubt that the game can't long be played without
competent and dedicated groundskeepers. But, it appears that
batters and pitchers with stellar stats are in shorter supply
than people willing to do a competent job of groundskeeping.
As far as we know, Buffett continues to draw an annual salary of
$100,000 as Chairman and CEO of Berkshire. No bonuses. No juicy
options deals. No BS. And, his long-term investment record is
at least as good as that of anyone at Salomon. Nonetheless,
efforts to bring their compensation into line with what Buffett
thought appropriate at a then-failing company were met with
massive defections to other firms.
If GM's top talent feels undercompensated, they too are free to
shop their abilities elsewhere. And, so are the metal stampers
at the Flint plant. But, the limiting factor on the latter is
the unlikelihood of any other company incurring a cost of $75 per
hour for a 4-1/2 hour workday.
"Bargains" Tend To Be Problematic
---------------------------------------------
[Reader:] Buffett and Munger: we prefer to avoid problems which
we can't easily step over.
[GADR:] Munger did not learn investing at Graham's knee.
Therefore, he was never enthusiastic about reclaiming cigar
butts. Of course, all of us prefer to pluck the low hanging
fruit, rather than to go out on a limb. But, 16 years into a
Bull Market, there aren't a lot of problem-free bargains out
there.
Yet, this is perhaps even more the case when poor business
conditions have driven the Market down. Indeed, a look at the
record shows that some of Buffett's "inevitables" seem more so in
retrospect than they did when he began buying them.
GEICO's shares had fallen from over 42 to just over 2 when
Buffett rescued it from bankruptcy's door in 1976.
The Buffalo Evening News had only meager profits and less than
ideal demographics when Buffett bought it. But, by starting a
Sunday edition, he was able to undermine the one profit center of
the only other newspaper in Buffalo, the Courier-Express. Though
the Courier-Express's eventual demise was inevitable, Buffett did
the right thing by Berkshire shareholders in giving the
Courier-Express a bit of shove toward the grave -- taking a lot
of press jobs with it.
The Washington Post was no great engine of profitability when
Buffett began investing in it. He was already on its board, and
helped stiffen Katherine Graham's spine, when she waged a 4-month
strike that broke the power of the Newspaper Guild at the Post.
Coca-Cola was one of the Dow stocks that did not recover
for several years after the Crash of '87, because Mr. Market had
started paying attention to its problems. The most famous of
these was the "New Coke" fiasco, but it was only one of many.
Salomon was nothing but problems when Buffett effectively took
control of it. Buffett would have preferred to avoid them, but
he didn't.
Given its exposure to the severely depressed California real
estate market, there was much doubt in the early 1990's that
Wells Fargo would survive. Buffett decided that it would, hence
"no problem".
What GADR Has "Urged" All Along
----------------------------------------------
[Reader:] If GM isn't truly that profitable, then why would GADR
urge investment?
[GADR:] For the past 3 years, what GADR has been "urging" is that
readers dollar-cost-average into an S&P 500 Index fund. Of
course, we had no inkling of how profitable that advice would
prove to be (so far).
The reason we gave this counsel is not because we foresaw how
successful it would be, but rather, because we believe it is
consistent with the goals of what Graham called the "conservative
investor", i.e., one seeking safety of principal and freedom from
bother.
"Safety", as Graham meant it, does not mean absence of temporary
declines in portfolio value, but rather, absence of risk of
winding up with worthless paper. Come what may, we see no
likelihood of the entire S&P 500 winding up worthless. And, no
investment program could be more free from bother than having
regular payroll deductions contributed to an Indexing product.
On the other hand, those who seek to beat Mr. Market at his own
game are what Graham called "enterprising investors". No matter
what best-selling books on investing may say to the contrary, the
odds of success at beating Mr. Market, as with any other
enterprise, are unlikely to exceed the time spent on the
enterprise. And, no amount of time expended will guarantee an
enterprise's success.
As it has turned out, $10,000 invested 3 years ago in the
Vanguard 500 Portfolio fund would now have a net asset value of
just over $22,000. No one, not even Vanguard founder John Bogle,
Sr., foresaw this degree of success (at the moment) of so simple
and passive an investment strategy.
Given the "buy-high/sell-low" dynamic implicit in Indexing,
combined with the near-term flattening, at best, of economic
fundamentals, there is very little likelihood of similar results
over the next 3 years. Nevertheless, GADR continues to urge that
readers be content to be conservative investors, by Indexing.
The reason for this is that, as mentioned above, beating Mr.
Market requires a lot of work, and the outcome is far from
assured. In this regard, it should be noted that those
investment greats who say it is "easy", nevertheless have spent
extraordinary amounts of time on the investment process
themselves.
Some Want To Beat Mr. Market At His Own Game
----------------------------------------------------------------
It is understandable that many readers of GADR, our promptings to
the contrary notwithstanding, want to be enterprising investors.
Our fallback suggestion is that rather than try this at home,
they instead "partner" with someone who is inclined to spend the
necessary time.
In this regard, we have presented a model Dow Value Portfolio, in
order to demonstrate the validity of GADR's valuation methods
over a 3-to-5-year time frame. The portfolio is restricted to
DJIA components because, given its universal recognition in the
investment world, the DJIA is the most unlikely venue in which to
search for "overlooked" bargains. If our methods work for the
DJIA, they should work even better in less closely followed
Market sectors.
We feel that these methods have already been vindicated in the
cases of IBM and AT&T. (Although, the latter's revolving door
policy on CEO's and overall business plans has caused some
concern). And, we feel it is just a matter of time before these
methods are vindicated in the cases of Boeing and GM.
The Pressure To Reduce Costs -- Now More Than Ever
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-----
The reason we are confident that GM will eventually become
"full-cycle" profitable is that we believe that the fundamental
premise of Capitalism is more operative now than ever before.
Simply stated, in a free market both capital and labor
both tend to flow toward uses which generate higher rates of
return, and away from those which generate lower rates of return.
Governments can and have thwarted the free flow of capital for
extended periods. The eventual result has invariably been the
same. Whether in Latin America, Africa, Great Britain, China,
India, Eastern Europe, or now, Japan and the rest of East Asia,
the outcome is that capital formation comes to a halt, and the
unemployment these market-thwarting policies was supposed to
avoid reaches epic proportions.
Today, the global markets for capital and labor have never been
more free of government interference. If Japan, a country
ideally suited by its culture to do so, cannot forever resist the
competitive pressure to rationalize its labor and capital
markets, neither can the management of GM and the UAW.
Is The U.S. Auto Industry At An "Infection Point"?
-----------------------------------------------------------------
On a related point, the above referenced Barron's article quotes
Furman Selz partner Maryann Keller as follows:
"For the past 25 years, we have seen the U.S. auto industry lose
ground against Japan. Now we are about to see things go the
other way. The Japanese don't yet know the game is over but, to
make it simple, they have totally lost competitiveness at a time
when Detroit has gotten much better."
Conclusion
--------------
In light of these irresistible free market forces, GADR's view
remains that GM's common stock is "Value Heaven".
*********
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Graham and Doddsville Revisited
Editor: Reynolds Russell, Registered Investment Advisor
web.idirect.com
Web Site Development/Design: ariana <brla@earthlink.net>
Consultants: Axel Gunderson, Wayne Crimi, Bernard F. O'Rourke,
Allen Wolovsky
In addition to editing *GADR*, Reynolds Russell offers investment
advisory services. His goal is to provide clients with total returns in excess of those produced by the S&P 500.
His investment strategy applies the principles of Value Investing
established by Benjamin Graham to the circumstances of today's economy
and securities markets.
For further information, reply via e-mail to: gadr@nyct.net
*********
"There are no sure and easy paths to riches in Wall Street
or anywhere else." (Benjamin Graham)
(C) Reynolds Russell 1998.
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