Aug 29, 2014 Investment Education: When Evaluating Management, Investment Analysts Beware!
This interesting historical lesson comes from early in my career as an investment analyst, but the message is just as valid today as it was then.
Before digital cameras became common, Eastman Kodak dominated the market for film and photofinishing. Kodak kept their selling prices for film and photofinishing high, enabling a number of independent photofinishers to gain market share by pricing their photofinishing services below Kodak’s. Kodak was able to keep the independent photofinishers relatively small, in some cases using tactics that might violate anti-trust laws; and in fact, one independent photofinisher, Berkey Photo, did sue Kodak for antitrust violations. That’s the background.
Now let’s look at Kodak. Kodak, at that time, appeared on everybody’s list of best managed companies. Earnings grew more or less steadily. The company periodically introduced innovative photographic products, making it hard for competitors to gain a foothold. Kodak knew its strengths and diversified into a number of related business, many of which would lose money in the early stages but had the potential to add significantly to earnings growth later on. Kodak’s management could speak articulately about each of these new product lines in terms of expected Return on Invested Capital, Return on Equity, Return on Assets, Gross Profit Margins, Operating Profit Margins, Asset turnover, and other investment ratios. It was evident that management understood its business opportunities well. Management would not give out the exact sales level and profit margins by product line, but they gave enough commentary that investors felt comfortable that they understood the company, and more importantly, that management understood their businesses well enough to consistently make good decision that would keep the company healthy and growing well into the future. In sum, Kodak was clearly a well managed company and deserving of the high evaluations it got from investors.
On the other hand, tiny Berkey Photo was frustrated by its inability to sustain growth. So Berkey sued Kodak for antitrust violations. And here is where it gets interesting. In lawsuits, there is a process known as “discovery”. Under discovery, each party to a suit, Kodak and Berkey in this case, is required to provide the other with information and documents that relate to the product lines which are the subject of the lawsuit.
As one might expect, Kodak strongly resisted revealing this information. Nevertheless, the court required Kodak to give the data to Berkey. This data, sales and profits by division, thus became public. When investors saw the data, they were astonished. It turned out that the profit margin on film was much higher than believed, and losses on some diversification products were much greater than believed. In retrospect, the company was making so much money on film that they could afford to (and often did) squander some of it on related product lines, and it would hardly be noticed in the overall results. The myth of kodak’s management quality was shattered. In retrospect, they had a goose laying golden eggs and nothing else much mattered.
The lesson here is that as investors, we are outsiders and can never know everything that is behind the numbers. In prior posts, my co-author and I have discussed the importance of evaluating management as part of a thorough investment analysis. We stand by that statement. But the lesson here is to remain skeptical. There may well be something you do not know that is important.
How does this translate into buy or sell decisions? For me, it is a reminder that even if things seem to be going well for a company, when its stock is selling at a high valuation, whether in terms of price/earnings ratio, enterprise value to EBITDA, or some other measure, it might be a good idea to sell a portion or all of my holdings. To paraphrase from Chapter 18 of our book, “If a stock is selling at the upper end of its historical P/E range, perhaps you should… sell some… not because it cannot go higher, but because the downside in the event of unexpected bad news is greater than the upside if all goes well.”
So this is a reminder to be skeptical about your own or others’ evaluation of management. In my next post, I will relate an experience that taught me to be skeptical of investment recommendations written by respected Wall Street Analysts.
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