Chapter 2: A Short Introduction to the Going Concern and Resource Conversion Views of Businesses

CHAPTER 2

A Short Introduction to the Going Concern and Resource Conversion Views of Businesses

In this book we advocate that outside passive minority investors’ (OPMIs) common stock portfolios consist of the issues of well-capitalized companies (strong financial positions), which should be acquired at prices that represent meaningful discounts from readily ascertainable net asset values (NAVs). Although this is a necessary condition for investment success (the avoidance of investment risk), it is not a sufficient condition.

The authors’ most successful investments have revolved around being in bed with superior managements who were able to be opportunistic on a long-term basis, say five years or so, in taking advantage of the resources in the business. In all cases, these resources included strong financial positions. Obviously, the businesses benefited also from the ability of management to create, or take advantage of, other resources, including having highly efficient manufacturing abilities (Toyota Industries); having the ability to make attractive acquisitions (Brookfield Asset Management, Wheelock & Company, and Investor A/B); having the ability to employ excess capital, that is, surplus-surplus, profitably (regional and community depository institutions); having the ability to access capital markets, especially credit markets, on a super-attractive basis (Brookfield Asset Management, Forest City); and having the ability to maintain profit margins during periods of increased competition and severe economic downturn (Japanese non–life insurers).

The underlying characteristic of these superior managements, in our opinion, is that they seem to focus on the same things we focus on as buy-and-hold investors; that is, long-term wealth creation. Unlike most stock market participants, the primary focus of these managements is not on what periodic reported earnings per share, or periodic EBITDA (earnings before interest, taxes, depreciation, and amortization), might be.

In creating wealth, these opportunistic managements realize that there tend to be many ways to create wealth besides enjoying operating earnings. These other methods of creating wealth include:

1. Enjoying super-attractive access to capital markets, both credit markets and equity markets.

2. Being able to make opportunistic acquisitions of other companies and other assets.

3. Being able to opportunistically launch new businesses.

4. Being able to take advantage of basic mispricings in securities markets in order to, inter alia, repurchase outstanding common stock, spin-off glamorous subsidiaries, or liquidate assets in whole or in part.

Focusing on long-term opportunism rather than periodic earnings per share, as reported, tends to not sit well with most OPMIs. A company with a strong financial position either does not need access to capital markets or else controls the timing as to when they would access capital markets. Given this, as a general rule, the managements will tend to be nonpromotional, and at times, hardly interested at all in what Wall Street thinks.

On the opportunism issue, we are convinced that it is very difficult for most management to be opportunistic if their company’s financial positions are such that the management has to be supplicants to creditors—whether those creditors be financial institutions, trade vendors, or landlords.

METHODS OF WEALTH CREATION

The above discussion highlights a view of businesses that is seldom articulated either in Graham and Dodd (G&D) or modern capital theory (MCT). How one views businesses has a profound effect on how one analyzes businesses. Throughout the book we shall make reference to the pure going concern view of businesses that is part and parcel of most conventional approaches to business and security analysis. We discuss this view below and explain why it has led to a myopic and very misleading understanding of how businesses generate wealth but nevertheless has become the conventional wisdom. More importantly, this myopic view, turned conventional wisdom, has had a profound effect on how many aspects of business and security analysis are handled; that is, from how managements are appraised, to how accounting numbers are used, to whose needs accounting rules must address, to substantively consolidating the interests of the company and its shareholders for all purposes. We contrast the conventional view with the view we hold that businesses and their dynamics are better understood as both having going concern characteristics as well as resource conversion characteristics. This latter view, which is a much more realistic representation of how U.S. and other corporations create wealth, enables us to develop a much richer framework for appraising managements as wealth creators, provides us a guide for using accounting numbers for what they mean rather than what they are, facilitates the identification of communities and conflicts of interests among business constituents, and as a result allows us and those using our approach to have much better chances at achieving long-term investment success.

THE PURE GOING CONCERN VIEW

A pure going concern is a business that creates wealth by generating flows from operations (either free cash flows or earnings) by conducting its day-to-day operations pretty much the same way it has always conducted them, managed pretty much the same way it has always been managed, financed pretty much the same way it has always been financed, and controlled pretty much in the same way it has always been controlled. Although we do not precisely know where this view originated, we can at least track it to Modigliani and Miller’s 1958 paper, “The Cost of Capital, Corporation Finance and the Theory of Investment,”1 which provides the formulation of today’s concept of enterprise value (EV) as the capitalized value of after tax operating earnings. Minor adjustments to this approach have also led to the discounted cash flow (DCF) valuation method. This view on how businesses generate wealth, which is implicit in most academic finance as well as in Graham and Dodd , has led market participants to overemphasize three factors in conventional security and business analysis:

Primacy of the Income Account, that is, the primacy of flows generated from operations as a valuation determinant—whether those flows are earnings flow or cash flows. (Earnings flows are streams of income, which create wealth for economic entities while consuming cash. In the corporate world earnings flows probably are more common than cash flows available for securities holders.)

Primacy of Short-Termism—Prediction of, and reliance on, immediate market prices and changes in those prices; these are crucial to equity pricing in securities markets dominated by OPMIs. Determining near-term outlooks for a company tends to be a much more important variable in conventional analysis than is determining underlying value.2

Primacy of Top-Down Analysis—The most important element in predicting market prices in conventional analysis are macro factors such as gross domestic product (GDP), the level of interest rates, technical market considerations, industry sectors, and the trends in stock market indices. For conventional analysis, micro factors looked at from the bottom up, such as loan covenants, appraisals of management, strength of financial positions, and access to capital markets are down-weighted compared to top-down considerations.

Moreover, under the influence of this view market participants tend to appraise managements only as operators. Managements will tend to be judged by their ability to improve margins, increase sales, organically grow the business, reduce costs, and so on. This one-dimensional view of management appraisal excludes other areas that are the purview of management including their abilities as investors (deal makers) and financiers. These activities can be orders of magnitude more important than operations in the generation of wealth, and are summarized in the saying “One good deal may create more wealth than 10 years of brilliant operations.” We discuss the appraisal of managements in Chapter 11.

Another area that has been profoundly affected by this narrow view of businesses is financial reporting; specifically how market participants and regulators view the role of Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). GAAP figures can serve two different roles for outside passive minority investors. First, an accounting number—usually earnings per share—is a tool to be used to help predict the price at which a common stock will sell in markets just ahead. Alternatively, all accounting numbers—the whole bookkeeping cycle—are tools to be used to give an investor objective benchmarks, clues to aid him or her in understanding a business and its dynamics.

The vast majority of analysts seem to view GAAP only in its first role, as a tool to be used to help predict the price at which a common stock will sell in the period just ahead. The regulators in the United States, whether governmental as embodied in the Securities and Exchange Commission, or private as embodied in the Financial Accounting Standards Board, seem to share the same view wholeheartedly. Estimating the market impact of accounting numbers is what counts for them. Thus, there is a primacy of the income account. There has to be as accurate a statement as possible of quarterly reports of income from operations; earnings before interest, taxes, depreciation, and amortization (EBITDA); and earnings per share (EPS). For those holding the view that businesses are pure going concerns, the focus is on an income account, or flow, number with full attention paid to what the numbers are, as reported, rather than what the numbers mean. We discuss these issues in Chapters 5, 6, 15, and 19.

THE RESOURCE CONVERSION VIEW

We view companies not only as having pure going concern attributes but, more importantly, as being engaged in what we call resource conversion activities. These activities include mergers and acquisitions, spinoffs, buyouts, recapitalizations, liquidations, changes of control, and other activities that generate wealth by putting resources to other uses, other ownership, and other control. Rather than being strict going concerns, virtually all businesses whose equities are publicly traded combine going concern characteristics with resource conversion (investment company) characteristics. As an illustration of this point, Table 2.1 shows the frequency of certain types of resource conversion activities for the companies in the Dow Jones Industrial Average Index for the five years from June 2007 through June 2012.

Table 2.1 Resource Conversion Activities of Dow Jones Industrial Companies from June 2007 to June 2012

Company Name	Number of Private Placements	Number of Mergers/ Acquisitions
3M Co.	1	27
Alcoa, Inc.	1	6
American Express Company	5	6
AT&T, Inc.	1	18
Bank of America Corporation	4	64
Caterpillar Inc.	0	13
Chevron Corporation	0	24
Cisco Systems, Inc.	14	44
E. I. du Pont de Nemours and Company	2	16
Exxon Mobil Corporation	1	36
General Electric Company	5	17
Hewlett-Packard Company	0	24
Intel Corporation	1	27
International Business Machines Corporation	2	44
Johnson & Johnson	0	10
JPMorgan Chase & Co.	7	33
Kraft Foods Inc.	0	8
McDonald’s Corp.	1	6
Merck & Co. Inc.	2	16
Microsoft Corporation	5	31
Pfizer Inc.	1	30
Procter & Gamble Co.	2	22
The Boeing Company	0	10
The Coca-Cola Company	1	12
The Home Depot, Inc.	0	3
The Travelers Companies, Inc.	0	0
United Technologies Corp.	0	3
Verizon Communications Inc.	2	4
Wal-Mart Stores Inc.	3	8
Walt Disney Co.	0	9
Table was built using S&P Capital IQ.

While income accounts, that is, flow data, are integrally related to net asset value (NAV), for many companies NAV and changes in NAV are far more important determinants of value than are earnings, or cash flows, from operations. Such NAV-centered companies include Berkshire Hathaway, almost all mutual funds, most income-producing real estate entities (such as Forest City Enterprises), most control investors (such as Brookfield Asset Management), and most conglomerates (such as Cheung Kong Holdings).

When one views companies as businesses combining going concern characteristics as well as resource conversion characteristics, the focus of analysis changes considerably since wealth is generated in a multiplicity of ways. Substantive areas where the focus of analysis changes are:

1. There is no primacy of the income account in the analysis because wealth is created both through going concern activities and resource conversion activities. The weight applied to the different activities in the analysis will be case specific. There are no general rules, only case-specific rules. We thoroughly discuss this point in Chapters 5, 6, 7, and 19.

Accounting numbers are analyzed for what they mean rather than what they are with a special emphasis to the entire accounting cycle not just one number. A thorough discussion of this point is given in Chapter 19.

The quality and quantity of resources of a company become important factors of analysis. As we said at the beginning of this chapter, one example of such resource is having a strong financial position. A strong financial position offers the OPMI’s insurance (minimization of investment risk) and management the ability to be opportunistic. We discuss these issues in Chapters 6 and 7.

Managements are no longer appraised only as operators but also as investors and financiers. We discuss this point at length in Chapter 11.

The focus of our approach is the avoidance of investment risk not market risk, which we discuss in Chapters 8 and 12.

There is no substantive consolidation of the interests of the company with those of the shareholders or any other corporate constituency. These issues are presented in Chapter 3.

Securities have substantive characteristics that must be understood. We discuss the substantive characteristics of securities in Chapter 4.

Portfolios of securities using our approach will tend to be concentrated rather than diversified. Diversification is a surrogate, and usually a damn poor surrogate for knowledge, control, and price consciousness. Diversification is discussed in Chapter 13.

SUMMARY

The remainder of this book is devoted to explaining and discussing all the elements of our approach. A key to understanding where these elements come from is realizing that businesses generate wealth in a multiplicity of ways, of which flows from operations (either cash flows or earnings) are only one.

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1 Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review 48, no. 3 (1958): 261–297.

2 This fact had been already pointed out as early as 1936 by John Maynard Keynes in Chapter 12 of his General Theory of Employment, Interest and Money (CreateSpace Independent Publishing Platform, 2011).