Saturday, July 2, 2016

Book review: "Everybody Wins! A Life in Free Enterprise" by Gordon Cain

Despite what its title suggests, Everybody Wins! A Life in Free Enterprise isn't an encomium to capitalism. Instead, it's the autobiography of Gordon Cain, a businessman who led four leveraged buyouts in the chemical industry during the 1980s. All of Cain's LBOs were wildly profitable: the best returned 240x its initial investment, while the worst returned a still-phenomenal 22x.

Cain wasn't a typical buyout sponsor: he was over 70 when he completed his first LBO, having spent most of his adult life until then as a manager in the chemical industry. But he wasn't a typical corporate manager, either. He was a freelance turnaround expert, helping several chemical companies salvage value from money-losing operations.

In this capacity, he acted purely as agent except for one instance: early in his career, he bought a failing perlite kiln and tried to turn it around. After three years of losses, he was broke and had to give up on the business. Unfortunately, the only turnaround in which he risked his own money was his only failed turnaround.

Cain's entry into the world of leveraged buyouts was accidental. In 1982, he joined a small mergers-and-acquisitions advisor called The Sterling Group after a heart attack forced its founder to retire. Sterling had arranged the sale of a building-products company called Balco, but the prospective buyer backed out at the last minute, so Sterling stepped in and acquired Balco itself.

This piqued Cain's interest in doing more LBOs. Undercapitalization and bad luck prevented Sterling from completing its next acquisition for two years, but when it finally happened, it was a far bigger deal than Balco: Sterling bought Conoco's chemical business for $600 million.

The acquisition of a fertilizer business followed later that year. In 1985, Sterling acquired several low-margin businesses from Monsanto. In 1987, it pieced together a collection of plants that produced ethylene and ethylene derivatives. All of these deals were exceptionally successful, earning levered returns of 2,000% or more within a few years.

High returns weren't the only thing that made the deals notable. Each LBO also included generous employee-ownership and profit-sharing plans. In each case, the executives got rich, many middle managers became millionaires, and even ordinary employees earned windfalls.

Reasons for Cain's success

I attribute Cain's success as a buyout sponsor to six things:

Domain expertise. He spent decades in the chemical industry as an operator, so he was better able to judge potential acquisitions than most buyers.

Contrarianism. He bought a styrene plant when demand was growing several percent a year but low prices had deterred the industry from expanding supply. He bought an ethylene plant when it had lost money for seven years and no new plants had been built during the same period. At that point, ethylene prices were near at a multi-year low even though the industry was operating at 94-95% of capacity.

Motivated sellers. Many of the plants he purchased were small, low-margin divisions of large companies. One purchase was a joint venture run by three companies with different interests–one of the three was the plant's biggest supplier of raw materials, while another was its biggest customer. The seller of Cain's fertilizer acquisition wanted to sell so that it could report the loss-making business as a discontinued operation. This seller took subordinated debt as partial consideration, effectively financing the acquisition for him.

Efficiency improvements. Since the acquired plants were previously part of large companies, they had few quality problems, but working-capital management and transportation were usually inefficient. In many cases, Cain was able to save money while taking money out of the business.

Good incentives. He implemented profit-sharing plans and solicited employee suggestions for how to improve efficiency.

Favorable financing. From 1984 to 1986, interest rates plunged and junk bonds became popular investments, enabling Cain to refinance his early acquisitions at favorable rates and pay the stockholders huge special dividends.

A well-written book with useful details

Cain is a good writer–he avoids the cliches and dead metaphors that make most business books painful to read. He also includes many financial details that will be of interest to investors. For each acquisition, he provides a breakdown of how financing was raised and how the money was spent.

Also interesting is his description of the mechanics of making an acquisition. Among other things, he mentions that:

• Prospective lenders often backed out at inopportune times. Bankers Trust almost ruined one of his deals by backing out at the eleventh hour.

• Many banks wouldn't lend to him unless he arranged long-term contracts for some of the acquired plants' output.

• He found big deals easier to do than small ones. Small deals required negotiating with junior managers, who would then need the approval of higher-ups to consummate any transaction. Large deals meant dealing directly with the higher-ups.

• Every acquisition he did had unforeseen delays. Sometimes aggressive lawyers, whom he calls "legal gladiators," delayed acquisitions by haggling over points that weren't important to either side.

• Lenders and ratings agencies were obsessed with numbers and had little understanding of the chemical industry's competitive dynamics.

• To sell junk bonds, he had to do "road shows" in which he met with prospective bond buyers. He found the road shows useless for raising money. Typically, whether or not someone bought his bonds depended on whether "they were satisfied with the last issue they bought from" the underwriter.

• Developing accounting and computer systems for the companies that he acquired was a big challenge. Each of these companies had previously been part of a much larger corporation and had never needed its own systems before.

Compounders don't have a monopoly on high returns

Cain's experience shows that compounding businesses don't have a monopoly on high financial returns. With the benefit of leverage, he earned phenomenal returns in a stereotypically mediocre industry. Even on an unlevered basis, his acquisitions quickly earned back their purchase price.

The key to his success was acting countercyclically–he invested money in the chemical industry when shortages were likely to lift margins far above their long-term average. Later, when margins normalized, he extracted capital rather than reinvesting at low expected returns.

Cain's attitude was far from the norm. As the book describes it, most chemical manufacturers were terrible capital allocators and invested pro-cyclically. Paradoxically, their bad investing was what made his strategy so lucrative–without overinvestment leading to prolonged gluts and disillusioning chemical producers, he never would have been able to make his acquisitions so cheaply.

Friday, July 1, 2016

Book review: "Capital Returns" by Edward Chancellor

Marathon Asset Management is a successful investment manager in London. It manages seven funds with long track records and, remarkably, each fund has beaten its benchmark by a wide margin over the past three, five, and ten years.

Capital Returns is a collection of letters that Marathon wrote to its investors between 2002 and 2015. The letters discuss individual investments that Marathon made, but they also act as showcases for the firm's investment philosophy, which emphasizes the importance of a phenomenon that it calls the capital cycle.

According to Marathon, the capital cycle has four stages:

• The prospect of high returns attracts new entrants to an industry
• Rising competition pushes returns below the cost of capital
• Business investment declines, the industry consolidates, and some firms exit
• Improving industry dynamics push returns above the cost of capital

Besides the cycle itself, Marathon cares about "how management responds to the forces of the capital cycle and how they are incentivised," i.e., how disciplined they are with regard to capital allocation. It also likes to invest in industries that are insulated from the cycle because they have strong barries to entry. Conversely, it avoids industries in which regulations and political meddling lead to chronic overinvestment.

Despite Marathon's prodigious investing success, I found Capital Returns underwhelming. Three things turned me off the book:

One, it's a greatest hits collection. All of the letters describe profitable investments Marathon made or unprofitable investments it avoided. Presumably there are times when the capital cycle is overwhelmed by other forces, and presumably it's possible to misjudge the cycle, but the book gives no such examples. Failure is often more instructive than success, so that was disappointing.

Two, the ideas are basic. Marathon may be the first firm to make the capital cycle the focus of its investing strategy, but sophisticated investors generally understand the concept. For instance, over the past few years many financial commentators have predicted that overinvestment in the mining industry would reduce its profits.

Three, while the letters are well-written, they're essentially all variations on the same theme. I think the letters are best seen as a form of marketing to Marathon's investors. By writing about the same topic every quarter, Marathon creates an image of thoughtful consistency. But the repetition that makes the letters successful as propaganda makes them tedious as a collection of essays.

Edward Chancellor's comments

Edward Chancellor compiled and edited the essays in Capital Returns. He also wrote its introduction, in which he summarizes Marathon's ideas and offers some of his own opinions. I think this is the best part of the book: it's more succinct than the essays, and his opinions by themselves are worthwhile.

Chancellor posits several reasons why the capital cycle happens. It's human nature to extrapolate the recent past forward. Many industries have low barriers to entry, so they're periodically flooded with new investment. Corporate managers garner higher salaries and greater prestige from managing larger companies, so they have an incentive to reinvest and make acquisitions regardless of likely returns. Investment bankers earn fees when their clients expand, so they likewise favor investment regardless of returns.

He writes that investment drives mean reversion for individual companies, industries, and entire countries:

Firms with the lowest asset growth have outperformed those with the highest asset growth.

Corporate investment in most developed economies... is a significant negative predictor of aggregate profitability.

Provocatively, he argues that value investors owe much of their success to timing the capital cycle:

[E]xcess returns historically observed from value stocks and the low returns from growth stocks are not independent of asset growth...

[M]ean reversion is driven by changes on the supply side which value investors who consider only quantitative measures of valuation are inclined to overlook.

Conversely, when value investors buy statistically cheap stocks but ignore the cycle, they're likely to lose money, as they did with housing stocks in 2006-08.

Drawing on Marathon's ideas, Chancellor makes two recommendations. One is to focus on supply rather than demand:

Supply prospects are far less uncertain than demand, and thus easier to forecast.

Another is to be an investing generalist. "Analysts with highly specialized knowledge of an industry are prone to" looking at their industry in isolation, whereas generalists consider historical comparisons:

[I]ndustry specialists end up not seeing the wood for the trees. They may, for instance, spend too much time comparing the performance and prospects of companies within their sector and fail to recognize, as a result, the risks that the industry as a whole is running.

I would qualify this criticism, however: I think that specialization is actually the key to Marathon's success. But rather than an industry, it specializes in an economic dynamic that affects numerous industries. This gives it focus that generalist lack while avoiding the tunnel vision that afflicts many industry specialists.