LETTERS FROM THE GLOBAL PROVINCE |
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GP 13 July 2005: Annual Reports from 2004: Hubris: The Fat Cat Gets Fatter The World Bubble. As we said last week, Paul Volcker, the very honorable, no-nonsense, one-time Chairman of the Federal Reserve, has warned us that the world is skating on thin financial ice: Yet, under the placid
surface, there are disturbing trends: huge imbalances, disequilibria,
risks—call them what you will. Altogether the circumstances seem to me as
dangerous and intractable as any I can remember, and I can remember quite a
lot. What really concerns me is that there seems to be so little
willingness or capacity to do much about it. (Volcker in the Washington
Post at
www.washingtonpost.com/wp-dyn/articles/ The world economy races along, out of control, propelled by a series of bubbles that central bankers and politicians in every major country show no inclination to prick. Curiously, our own Alan Greenspan, who should know better, seems hesitant to rein in our excesses and is loathe to speak out about them, only putting out a dimly lit caution light perhaps once a year. Our runaway real-estate markets, even bigger puff pastries than our overheated stock exchanges, are showing some weakening in Florida and a few other parts of the country, easy money no longer propping them up. Annual Report on Annual Reports 2005. It is against this backdrop that we are writing this year’s report on annual reports, an exercise we have been doing for more than 20 years as an aid to institutional investors and a small coterie of multinational leaders. (For reports dating back to 1994, see our Archive at www.globalprovince.com/annualreports.htm.) Last year’s report, “The Uncertain Club vs. The Globe Trotters,” found chief executives to be quite unsure of themselves and very muddled about the future. In stark contrast, the 2004 batch of reports displays an army of bosses who are cocksure and overwhelmingly confident that they can deliver numbers for years to come that will dazzle our eyes. In our 30 years’ reading of annual report tealeaves, we have never detected such a disconnect between the mood of our political and business leaders and the actual state of our economic fundamentals. Sort of like the French royalty before the Revolution. All this in a world that looks like it may come unglued, sooner rather than later. Hubris. We learn from our handy encyclopedia that the Greeks called this “hubris,” a condition where we begin to think we are more powerful than the gods, and the gods in turn strike us some very mortal blows to remind us we are mere men. We also learn there was a goddess called Hubris who personified this disease and who spent a bit too much time in tete-a-tetes with mankind. Beware the chattering classes. (See http://en.wikipedia.org/wiki/Hubris.) We are fond of saying that when times are bad, leaders share the blame with everybody in their retinue and even find that the gods, weather, business conditions, and other demons are amongst the reasons why their companies are faltering. When their companies are doing great, the bosses manage to take credit for their windfall. Right now they’re riding high. Oil and Housing. The chiefs of housing-related and oil companies managed to crow about their 2004 results, glossing over the worldwide real estate rampage and the general commodity bubble that have a whole lot to do with their heydays. Lowe’s, a southeastern building supply house, says, “2004 was another great year for Lowe’s," driven by “excellent customer service and store-level execution” and the addition of 140 new stores in “great markets.” Chevron Texaco chortles that it “delivered the strongest financial performance in” its “125-year history.” “Our performance was driven by executing well against the right strategies at the right time.” Exxon Mobil, sounding like a newly minted MBA, claimed it had “created sustainable competitive advantage through our proven business model, enabling us to excel while taking on the world’s toughest energy challenges,” producing “Record earnings—highest in the history of the Corporation and in each business line.” The oil majors, incidentally, have been under-investing in exploration and in new energy technologies, although we anticipate that they will begin to act more like geologists and less like bankers in the latter part of this year. A Blow-Out of a Party. But companies in many other industries were also smoking big cigars and hoisting glasses of champagne. GE, which has been spinning off $15 billion worth of businesses, while ploughing $60 billion into new areas, is ready to announce it’s a growth company now, with the goal of growing 8% a year, instead of its traditional 5%, linked to hefty spikes in earnings and return on capital. At the end of fiscal 2004 (March 31), Toyota, too, talked about its relentless quest for growth, strongly re-iterating its plan to capture 15% of the global auto market by 2010. Now perhaps the world’s best car company, it sold and produced record numbers of vehicles in fiscal 2004, while posting highs in revenues, operating income, and net income. Says President Fujio Cho, “I believe, no matter what the era, a company that has lost its appetite for growth cannot develop. In my view, sustained growth drives corporate value.” Swollen ambition has touched several other companies. “John Deere had a terrific year in 2004: Our actions to build a great business combined with better market conditions to drive sales and earnings to record highs.” Donald Graham at the Washington Post, whom we have always regarded as a fairly sober fellow practically shouted: “One statistic sums it up. Operating income of $563 million was $175 million higher than the best year we ever had…. It is especially pleasing to report that every division of the company participated, growing operating income over 2003.” The irrepressible, big man in a small pond, Robert Shillman of Cognex, a machine vision company whose reports always try to be a little comedic, did an annual report in the style of the dummy books (www.dummies.com/WileyCDA/Section/id-100052.html) where he tells you all the smart things he did in 2004. But a Deflated Celebration Nonetheless. Despite the multi-colored balloons, the party seems to be a bust. Back in the 20th century, when the modern annual report was invented, good design and editorial invention lent much more esprit de corps to the world of reporting. We can remember the very year when a market-driven IBM made the transition from a small, dry annual report with a short income statement and balance sheet to a 4-color extravaganza. This year, with the possible exception of Southwest Airlines, which has some fizz in its report, annual reports in this country are flat, lacking in joie de vivre. The cover of Southwest says, “Ding: You are now free to move about the country.” The Southwest report is chockablock full of action leisure photographs that show Americans letting the good times roll—bon temps rouler. In contrast, many reports are now put out on cheap, flimsy paper, wrapping a president’s letter around the official 10K annual report filing document that is sent to the SEC: such companies look like they are going out of business. One of our partners once said that a floppy annual report is very much like a limp handshake. Annual reports 2004 are very dour and hopelessly thick, the optimistic words notwithstanding. They’ve gotten as dull as The Wall Street Journal. Overseas. Many overseas companies know what Americans have forgotten. The hard-copy printed paper annual report is a calling card used when seeing possible merger candidates, officials in foreign governments, investment bankers, and major customers across the globe. Today, we find that companies in Europe and Asia have taken the lead in annual reporting, not afraid to show a little flair. We are fond, for instance, of the reports of Germany’s Vorwerk, which in 2004 talks about the theme of courage; of Austria’s Wolford, a lingerie maker with a better eye for women than Playboy; and Finland’s Fiskars, which makes the scissors and other well-wrought household tools affluents in America love to have. Sarbanes Oxley and tired American mid-level managers have made top executives forget that the annual report is primarily the company’s best marketing document, and neither an online Internet annual report nor a depressing paper wrapper will do the job. Cautionary Notes. Not every chief executive is smoking pot or otherwise blown away. Lee Scott of Wal-Mart knows he has a few troubles: “Even though our financial results were solid, I would characterize the year as good overall.” And Warren Buffett, whose growth in book value per share since 1999 has generally been below his average gain of 21.9% from 1965-2004, realizes that Berkshire Hathaway is not all that it was: I didn’t do that job very well last year. My hope was to make several multi-billion dollar acquisitions that would add new and significant streams of earnings to the many we already have. But I struck out. Additionally, I found very few attractive securities to buy. Berkshire therefore ended the year with $43 billion of cash equivalents, not a happy position. The trouble with Berkshire and Wal-Mart is that they’re so big they have become proxy cards for the American economy, and that economy is in trouble. Foreign Currencies. “Berkshire owned about $21.4 billion of foreign exchange contracts at yearend, spread among 12 currencies.” Buffett, you will understand, has traditionally been a buyer of America and certainly not a foreign currency speculator or an amateur George Soros. “But the evidence grows that our trade policies will put unremitting pressure on the dollar for many years to come—so since 2002 we’ve heeded that warning in our investment course. (As W. C. Fields once said when asked for a handout: ‘Sorry, son, my money’s tied up in currency.’)” Buffett’s currency buying, of course, brings us back to Volcker’s warning that things have never been so risky, and that America’s trade imbalance is running down our economy. This has lots of implications for investment beyond Berkshire’s currency excursions. Mis-Allocation of Capital. There’s a lot of money sloshing around in the world’s financial markets. You only have to look at some of the ridiculous mansions, virtual dormitories, going up in your neighborhood to understand that the nouveau riche have never been so nouveau. In business, this pot full of cash is leading to some bad business decisions. On July 11, a Wall Street Journal headline (p. C1) screamed, “Cash-Rich Firms Feel Pressure to Spend.” We suspect that even Warren Buffett may wind up putting some of his $43 billion down some black holes. It’s not just Mr. Buffett who’s having a hard time disposing of his money. The surfeit of unregulated hedge funds has resulted in a bunch of money chasing too few investment opportunities. Their performance has gotten in trouble. Running responsible reformist Bill Donaldson out of the SEC and Washington will surely exacerbate the scams cropping up in the hedge world. Corporate America probably isn’t any wiser. It’s not at all clear that major companies are putting their money in the right places. We’ve already mentioned under-investment by the petroleum majors. But even a P& G arouses some questions. It is going for mega brands in mega markets. It now has put its horsepower behind 16 billion-dollar brands, and it has 10 more behind them ranging from $500 million to almost a billion in sales. It wants to focus on big brands in big countries, and it is particularly watching 10 lead countries. We cannot tell which countries, because, even with Sarbanes Oxley, P & G 2004 is not as transparent as it might be about its considerable foreign sales. On the one hand, it is a virtue for the king of branding to focus on building humongous brands in the world’s jumbo markets. Branding is what it knows how to do, which is ironic, since the Proctor and Gamble people in Cincinnati are a somewhat anonymous bunch—faceless people crafting high image products. However, we spelled out in “In Search of Governing Ideas,” that the developed nations of the world are lagging, and the real growth is coming from the emerging, “off-the-map” countries. As C. K. Prahalad has pointed out, there’s a whole lot of growth and margin to be had in the less visible markets we are inclined to ignore (www.conference-board.org/articles/atb_article.cfm?id=273). Will the big countries implode along with P & G’s brands? Are all our products becoming unwieldy SUVs just when the world is ready for agile hybrids? Perhaps one needs to devise more small brands for small countries. Why are corporate leaders feeling so rosy when Volcker finds reasons to quake? Why are corporate leaders making risky investment decisions (particularly oversized, overpriced acquisitions) or putting money in the wrong places? It has been noted that our business chieftains are very richly compensated, no matter how their companies perform. Imitating their overpaid investment bankers, they have become fatter and fatter cats. Perhaps this puts them in another solar system distant from the reality of customers and consumers worldwide whose circumstances are considerably more straitened. In any event, there is some evidence that chief executives are currently very much out of touch with their marketplaces. Investment Conclusion. You might get the feeling that’s there’s too much money sloshing around, with lots of overspending for the wrong things. And you would be correct. Of course we can see that in Iraq which is consuming dollars we can ill afford to throw away. But, from the 2004 reports, we also smell a lot of money in the private sector that is burning a hole in executive pockets and being dribbled away in pursuit of imaginary ROIs. We will be issuing a new Investment Outlook in coming weeks. Given the over-confidence of too many CEOs, we will be suggesting that one go well off the beaten path to find new investments. In an unstable world, most mainstream companies in big economies are overpriced. We think you, just like Mr. Buffett, are faced with over-valued companies and several major economies that are not on a good footing. Since you cannot safely invest in the present, you should probably think long term, trying to put your money into the future, if you can figure out what that is. Think distant. P.S. We will post this report in our Annual Report section as soon as we have made some modifications and added some citations. P.P.S. GE, at least, is on the right issue. How do you grow when the major economies are marking time? Notice that it is going to unexpected places, expanding in developing economies, putting heaps of capital into infrastructure markets. P.P.P.S. We’re rather partial to Mr. Buffett, since his stock gave us our grubstake eons ago, well before anybody was paying any attention to Berkshire. That’s why we talk about him so much. He impressed us before he started hanging out with Bill Gates and Mr. “Hank” Greenburg of AIG. We liked the other Hank Greenberg who hit 58 home runs for the Detroit Tigers in 1938, later became a successful General Manager of the Cleveland Indians as well as an investment banker. P.P.P.P.S. We have yet to discover a good Internet annual report. Companies spend a fortune putting out their multimedia monstrosities. |
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