Saturday, August 22, 2015

Book review: "The White Sharks of Wall Street" by Diana Henriques

The White Sharks of Wall Street is primarily a biography of Thomas Mellon Evans, a corporate raider who began his career during the Great Depression and rose to prominence after World War II. The book is also a survey of his contemporaries: several other corporate raiders became prominent in the 1950s, although none of them matched Evans's success or longevity as an investor.

Evans was a poor relative of Andrew Mellon's family, and his first job after graduating from Yale in 1931 was working for the Mellon-controlled Gulf Oil. He began investing in stocks around the same time, specializing in buying net-nets, which became plentiful as the Depression worsened.

After several years of working at Gulf and investing successfully, he convinced his rich relatives to bankroll his acquisition of an entire company: H.K. Porter, a manufacturer of steam engines. Porter had gone bankrupt as diesel engines rendered steam obsolete, and Evans took control of the company by buying its bonds at ten cents on the dollar.

The investment wasn't successful at first: Evans tried and failed to expand Porter's product line, and a boardroom revolt nearly forced him out of the company. His fortunes improved during World War II when ammunition factories, which couldn't use diesel engines because of the risk of explosion, began ordering steam engines.

After the war, he used Porter as an acquisition vehicle. His first acquisition was the Mount Vernon Car Manufacturing Company, which he bought for less than the company's cash on hand. The seller was a family trust. Later acquisitions came from the same mold as Vernon: they tended to be small manufacturing companies with unsophisticated owners and few rival bidders, so Evans was able to buy them cheaply. He also repurchased Porter stock when it became a net-net.

All of the companies he bought were traditional manufacturing companies-- his approach of buying an underperforming business, selling assets, and cutting costs probably wouldn't have worked for a consumer-facing company.

This acquire-and-liquidate strategy often generated hostility, and Evans was considered pushy and obnoxious. When he acquired Mt. Vernon, he had difficulty getting a bridge loan even though it posed almost no risk to potential lenders.

Although the cultural barriers to corporate raids and liquidations were high, the legal barriers weren't-- at least at first. The SEC didn't mandate 13D schedules until 1968, so surprise raids were possible, and were practiced with increasing frequency, before then. As corporate raiders began winning proxy fights, corporate managers devised new defenses and lobbied state governments to pass anti-takeover laws.

Despite these challenges, two things made corporate raids remunerative.

Excessive conservatism was one. The Great Depression had ended only with the start of World War II, and people thought that high wartime profits would give way to another lean decade, necessitating that companies hold large cash reserves. They didn't foresee that the destruction of America's economic rivals-- and demand for American goods to rebuilt them-- would lift profit margins for an entire generation.

Principal-agent problems were the other. As the book describes it:

As more of corporate America's stock came into the hands of mutual funds and other passive institutional investors, the power of the shareholder... had become weaker and less effective. By the 1950s, most chief executives had been essentially liberated from the need to cater to shareholders at all... In the robustly profitable 1950s, for example, corporations were paying out substantially less of their profits in the form of dividends than they had paid in the boom years of the 1920s.

Besides Evans, some the prominent raiders of the late 1940s and 1950s were Charlie Green, Leopold Silberstein, Louis Wolfson, and Robert Young. Many of these guys eventually fell by the wayside-- in general, they were better at identifying undervalued businesses than at running them. Also, railroads were popular activist targets, and railroad profits fell significantly in the mid-1950s.

Takeovers continued in the late 1950s and 1960s, but they increasingly became friendly: conglomerate-builders like James Ling replaced corporate raiders as the main acquirers. The book notes that:

Although Ling's approach-- borrowing money to buy a company and paying off the debt by selling some of its assets-- was exactly how Tom Evans had acquired Mount Vernon Car Manufacturing Company in 1944, Evans considered most of the newcomers' acquisition strategies foolish because they often came at the expense of real shareholder value.

As the environment changed, Evans changed his modus operandi to buying a minority stake in a company and launching a tender offer. This would prompt his target would seek white knight, letting him sell his stake at a profit. His intent wasn't to solicit greenmail, although he took greenmail from Morrison Knudsen in 1978.

He conducted only one hostile takeover late in his career, launching a tender offer for Missouri-Portland Cement in 1975. After he'd acquired half of the company's shares, he took it private through a leveraged buyout in 1977, years before the LBO mania began.

During his decades-long career, Evans was an early practitioner of many things that later became popular: net-net investing, corporate raids, financial engineering, conglomeration, greenmail, and finally leveraged buyouts.

Apart from his financial genius, he had few admirable qualities - his second wife shot herself after he cheated on her, and he had a strained relationship with his children. Ironically, two of his sons became CEOs of public companies, and each fended off a hostile takeover in that capacity.

Another irony was that Evans retired in the early 1980s, just as the great bull market began and other investors got rich doing the things he pioneered. It took Evans 35 years to make a hundred million dollars, but the bull market allowed some of his imitators to amass comparable fortunes in less than a decade.

Friday, August 21, 2015

Quick note: a comparison with 1994

American stocks have plunged during the past few days, and that's led some market commentators to draw comparisons between today's market and the volatile markets of 1987 and 2008. I think 1994 is a better comparison.

In 1994 the S&P 500's net change was minimal, but many financial markets experienced significant volatility. Oil, emerging markets, and junk bonds all fell, like they've fallen this year.

The S&P 500

In the six months from October 1993 to March 1994, the S&P 500 traded in a narrow range before falling 7% in six trading sessions. It subsequently rebounded and ended calendar-year 1994 down 1.65%, although the total return was positive thanks to dividends.

In the past six months, the S&P 500 has traded in a narrow range before falling 6% in four trading sessions so far.

Many market pundits have commented on the stock market's weak breadth this year. The same dynamic existed in 1994. In the months before the market broke down, the NYSE advance-decline line was noticeably weak.

Corporate debt

Junk bonds and investment-grade bonds both fell 3% in 1994. They're down by comparable amounts so far in 2015.

Crude oil

From October 1993 to March 1994, crude oil fell 27%, staged a dead-cat bounce, and then fell back to its lows.

During the past twelve months, crude oil has followed the same pattern of a large decline, a dead-cat bounce, and a second decline, but the percentage moves have been twice as large and it's taken twice as long to play out.

Emerging markets

In 1994, emerging-markets stocks and bonds underperformed their first-world counterparts by double digits. So far in 2015, emerging markets have significantly underperformed developed markets.