Is Price Everything? (A Thought Challenge For Value Investors)

A thought exercise. You're attempting to evaluate a business for investment.  Here are some of the rough data points you've managed to gather through a quick investigation.

1. Market Size. 

This is a situation in which the service offered by the business has helped create a market. It did not exist before. So its size is unknowable. 

You have no way to quantify this, but it's beyond evident that it's large. Very large. Many billions. And it's growing.

The service provides a clear value for clients, a point so obvious that it's not even worth debating.

Today, the company holds a dominant share of the market.

2. Competitive Advantage.

The business you're evaluating appears to have several levels of competitive advantage protecting its services in the market. 

It's developing a scale cost advantage, though that's not yet established. But it does have the market share lead over competition, and once scale is established it seems highly unlikely it would cede ground to a foe. 

It has early brand appeal with customers preferring its services, even in cases when it competes against free alternatives. 

And it's establishing a network effect whereby the range of services it offers tie in tightly with customer mission-critical needs. In other words, the more they use it, the more difficult it is to leave it.

The company has a culture of innovation, and it's constantly rolling out new offerings as part of its services. And it likes to surprise customers from time to time by offering the same services, with additional features, but at a lower price point.

3. Economic Model.

While there is scale cost advantage, the scale is not yet sufficient for the venture to be profitable. So it's losing money both from an income statement perspective and in terms of cash returned on invested capital. This could continue for a few more years.

It's a model in which heavy fixed costs must be recouped by a tremendous volume of sales with low gross margins. 

But you can reasonably conclude that the business will reach scale and therefore benefit from a profitable economic model (indeed, one with extremely high ROIC), but not before it suffers heavily for these investments.

4. Price.

This business currently has no earnings, and its losses will mount for at least a couple more years. Its assets depreciate rather quickly, so there's no meaningful liquidation value. 

That said, investors are assigning it value. The market seems to hold high hopes for its future.  Optimism abounds. 

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So do we put this immediately in the "too hard" bin? Turning up our nose because we wear the VALUE INVESTOR badge, and we only buy cheap stuff come hell or high water?

What of the large and growing market? What of the economic model showing high ROIC...or the ability to compound earnings at a high rate of return as it expands its share of that market? What of those competitive advantages that seem very likely to ensure that the business maintains its market leader position and protects the stream of profits generated from holding the lead?

Each of those variables makes it likely (and you can go out on a ledge and assign a high degree of probability to it) that this business will be large, profitable, and immovably entrenched five years from now. 

In the meantime, it will lose money. You will suffer these losses. It's likely to make for a bumpy ride. Volatility will ensue. 

But in five year's time, it will be a franchise. 

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Under that banner of VALUE INVESTING, we often miss the forest for the trees. We fixate on price, convinced that TRUE value investing demands we only place our hard earned dollars behind businesses sporting some low-price valuation measure.

The purpose of all investing is compounding your returns, and when you can do it with low risks...gravy. But is PRICE necessarily the center of the universe? Or is it one variable to consider among others that should hold weight in your decision process?

Truly great businesses are few and far between. They don't often come cheap. That's not to rationalize an expensive purchase. But expensive is only expensive if the value doesn't compound. If the market isn't as big as you imagine, or the economic model as lucrative, or the competitive advantages as deep. But if they are as reliable as your analysis suggests, the power of compounding can make something that appears expensive today seem like peanuts in retrospect.

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For the record, I've not invested in the unnamed business considered here. But there's only one reason why...

Optimism. The business is currently awash in optimism for its future. Many people have analyzed it and reached similar conclusions to me. 

But I suspect their optimism knows boundaries. The business is certainly engaged in a high wire act in suffering losses to grow its market share and reach scale cost advantage. The price will fluctuate. Earnings will not improve quarter over quarter. And those lacking intestinal fortitude will not enjoy the view of a long drop from the wire. 

I'll revert back to this Warren Buffett quote last posted under No Extra Credit for Being a Contrarian:

The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.

I hold out great hope for calamity. My optimism in the market's eventual pessimism knows no bounds! And in the meantime I wait. 

Whom Does Management Serve?

This week I've been a bit obsessed with the idea that the manager's job is to represent the interests of shareholders. It brings to mind the Yogi Berra epithet: 

In theory there is no difference between theory and practice. In practice there is.

In theory it makes sense. Companies are vehicles for invested capital to find returns. We entomb that concept in law and in corporate structure where the board of directors is explicitly charged with representing shareholders. Managers run the day-to-day and should have investors' interests on their minds, remaining on constant look out for ways to increase shareholder value. 

But we put the idea in play, how does a manager best represent investor interest? Indeed, which investor?

Investors are far from a like-minded group bound together by common interests in the business' success and united in their opinions on how that success is best achieved. Oh no. To highlight just a few investor archetypes:

There are the hedge fund traders, moving in and out with positions measured in millions of shares and closed out within minutes or hours when the stock moves up or down by a penny or two.

There are the pension funds for (as an example) retired nuns. They hold shares for years but issue measure after measure for shareholder consideration on such social issues as whether you should offer health benefits to your lowest paid employees. 

There are the corporate raiders that accumulate massive positions, gain board representation, and then force management to monetize assets and distribute the cash. This pushes the share price up for a time, during which the raiders sell out and move on to their next target.

All are investors in your public company. Each has very specific objectives. And those objectives are divergent and irreconcilable.

So, how does management effectively represent investors when their interests don't align?

As a frequent visitor of Charleston, South Carolina, I've been required to read the works of native son Pat Conroy. My favorite book is his memoir My Losing Season in which he details his time playing basketball for the Citadel. 

The Citadel, a military prep college in Charleston, is hard on its first year students (called "Knobs"), believing it must break each of them down and build them back up again in its own disciplined model. Conroy was not spared the hazing rituals. In a particularly poignant scene from the book he recalls being surrounded by several upperclassmen who begin demanding he do a variety of conflicting activities. As I recall, one would get in his face and scream that he do push-ups. Another would degrade him for doing push-ups, telling him he's supposed to jump up and down. And yet another would scream at him for jumping; he should be reciting the school's creed. 

The demands came rapid fire. After several minutes of this Conroy was a wreck. He instinctively fell into fetal position on the floor, his mind unable to process another command. The older cadets walked away, satisfied that they had broken this cocky Knob.

The human mind cannot process conflicting orders without freezing up. It's simply not how our wiring works. And so, while the idea that management works for investors sounds good in theory, in practice it's unworkable. Many an executive has driven himself to exhaustion trying to appease these feckless masters. 

What's a manager to do?

Focus on the business itself.  Use the overall health of the business as a proxy for the long-term investor...that investor whose interests are aligned with the company investing in its advantages, foregoing immediate gratification en lieu of higher earnings further down the line. 

These are the businesses I want to invest in. The opposite are those that pledge allegiance to blind total shareholder return, returning cash to investors that could be reinvested in the business to fortify its barriers to entry, improve its offerings, or make itself invaluable to its customers. 

Pricing Power Part III: Amazon.com As Vehicle For Low Price/Scale Cost Advantage

The first form of pricing power is the ability to raise prices or continually charge a premium (featured in this post). The second is the ability - and willingness - to lower them. We discussed the general benefits (here). Now we will look at how it applies to Amazon.com specifically.  

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In November 2011, Wired Magazine featured a Jeff Levy interview of Amazon CEO Jeff Bezos. Here is an excerpt:

Levy: Speaking of pricing, I wanted to ask about your decision to include streaming video as part of Amazon Prime. Why not charge separately for that? It’s a completely different service, isn’t it?

Bezos: There are two ways to build a successful company. One is to work very, very hard to convince customers to pay high margins. The other is to work very, very hard to be able to afford to offer customers low margins. They both work. We’re firmly in the second camp. It’s difficult—you have to eliminate defects and be very efficient. But it’s also a point of view. We’d rather have a very large customer base and low margins than a smaller customer base and higher margins.

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Blake Masters has done the world a significant favor by blogging his class notes from Peter Thiel's lectures. Thiel was a founder of PayPal and now runs the Founders Fund. He was profiled in this New Yorker piece last November (2011).  The class is CS183: Startup, and the notes are a fascinating read. You can access the blog posts here.

In talking about competitive advantage, Thiel had this to say:

For a company to own its market it must have some combination of brand, scale cost advantages, network effects, or proprietary technology...Scale advantage comes into play where there are high fixed costs and low marginal costs. Amazon has a serious scale advantage in the online world. Walmart enjoys them in the retail world. They get more efficient as they get bigger. 

Plenty of businesses have achieved scale sufficient to make them lower-cost producers than competitors that don't have the demand to manufacture as much of a similar product. These businesses can do a variety of things to press their scale cost advantage, one of which is to lower prices to a point where the competitors cannot follow suit and still maintain an adequate return on investment. But the scale advantaged business can also charge a premium, sinking its cost advantage into (for example) marketing campaigns that build a brand around the product.

To offer low prices, the company has to make a conscious decision that it will not exploit its advantage by charging a premium and using the scale cost advantage to make its margins even fatter. It must commit itself to a bigger vision of what can be accomplished by lowering price even when your advantage doesn't demand it.

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As we explored in our previous post (here), several retailers have built advantages around themselves by being low-cost low-price. But to date, their ambitions have been fairly limited to the retail industry. In many ways this makes sense...we encourage management to stick to its knitting, focus on its core, avoid (as Peter Lynch labeled it) "diworsification." A&P, Walmart, Costco and Home Depot have all demonstrated the scale cost advantage in retail.

Amazon is doing the same thing in web retail, and it has the additional advantage of an even lower overhead structure than the traditional retailers by virtue of being web-based instead of store-based. For example, Walmart has about 10,150 stores world wide that produced $444 billion in revenue last fiscal year. That's an average of $44 million per store. Costco has 600 warehouses that generated $89 billion in revenue. That's $148 million per warehouse. Amazon runs 70 fulfillment centers and generated $48 billion in revenue for an average of $685 million.

That's a tremendous amount of volume run through each warehouse. It clearly creates an advantage in fixed costs. It's a key component of how Amazon works "very, very hard to be able to afford to offer customers low margins."

It's predicated on the simplest of assumptions: when given the choice between a high price and a low price, consumers would prefer to pay the low price.

But it paints an incomplete picture to see Amazon only as a retailer; to think about low-price pricing power in terms of offering products at a cheaper price than other retailers. Amazon has a broader base of business operations and much wider ambition for where it can apply its low-cost low-price model.

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So what is Amazon? Let's try this interpretation on for size...

AMAZON IS A VEHICLE FOR APPLYING SCALE COST ADVANTAGE TO ANY INDUSTRY WHERE HEAVY VOLUME OF LOW MARGIN SALES CAN OVERCOME HIGH FIXED COSTS TO GENERATE SATISFACTORY RETURNS.

Retail is but one application of this Amazon business model, albeit a very important one. Retail has allowed Amazon to create an infrastructure that has progressed, adjacency by adjacency, into new product categories, new geographies, and new services. Leveraging, along the way, its technology, procurement, and fulfillment capabilities to facilitate the growth.

(Retail has also provided it a large cushion of cash, that large and growing pot of cash Amazon gets for getting its receivables much more quickly than it must write checks for its payables or other commitments.  That's about $10 billion - which will continue to grow as long as Amazon keeps selling products quickly - that Amazon can use for whatever purposes it wishes. And that capital carries with it no cost (as would debt), no dilution (as would issuing new equity), and no demands from Wall Street (as often happens when you ask outside sources of capital for money to finance your initiatives).)

Where else can the model apply beyond retail?

Consider the following exchange between Levy and Jeff Bezos in the Wired.com interview quoted above:

Levy: Young startups all tell me that even if Google offers them free hosting, they still want to use Amazon. Why do you think that is?

Bezos: We were determined to build the best services but to price them at a level that customers couldn’t match, even if they were willing to use inferior products. Tech companies always have high margins, except for Amazon. We’re the only tech company with low margins.

Has Bezos put the technology world on notice? What happens when Amazon exports this scale cost advantage from web retail into technology's fat profit domains, lowering prices for customers by sticking to its low-cost low-price approach to business?

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Below, a letter from the Amazon.com homepage at the launch of several new Kindles. See Bezos strike the steady drum beat of that message he shared in the Wired.com interview...

Pricing Power Part II: Lowering Price As Competitive Advantage

The first form of pricing power is the ability to raise prices or continually charge a premium (featured in this post). The second is the ability - and willingness - to lower them.

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It's easy to understand the model of charging high prices for your products and services when you're able. We grasp the concept as an elementary principle of business, and its logic flows naturally: if you can charge a higher price, you gather a higher margin. More gross margin dollars give you the walking around money you need to pay competitive salaries for the best talent, to hire the best sales force, to build the most recognizable brand, and to plow money back into research and development. Then you should have plenty left over to pay the tax man, and whatever remains either goes back to shareholders or is plowed back into the business in a way that increases its value over time.

It's far less intuitive to grasp how charging a lower price is another form of pricing power that belies competitive advantage. Our first impulse is to think that lower prices lead to lower margins, leaving less to cover operating expenses and even less to drop to the bottom line.

That's all true. But not always. Certain complicating factors can arise: like customer price sensitivity affecting demand...and increased demand driving greater market share...and greater market share producing higher sales volume...and high sales volume creating scale advantages.

As we stated in regards to businesses that can charge high prices for their offerings (this post):

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term...or whether it's fleeting and likely to dissipate with time.

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I'm no business historian, but my survey-level reading leads me to this abbreviated chronology of the "low price as advantage" strategy.

Begin With The Great A&P 

First, notwithstanding the travails of their business in the current generation, A&P stumbled first upon the idea of using low prices to generate high volume. In the book The Great A&P and the Struggle for Small Business in America, author Mark Levison attributes this simplest of quotes to co-founder John A. Hartford:

We would rather sell 200 pounds of butter at 1 cent profit than 100 pounds of butter at 2 cents profit.

A&P's founders uncovered the basic tendency of grocery shoppers to buy a lot more when prices are lower. As long as the grocery store could afford to charge less it would steal market share from the traditional mom-and-pop grocers. A&P used that philosophy as the cornerstone of its expansion and grew into the largest and most powerful retailer the world had know up to that point. 

Lesson learned: Grocery shoppers are price sensitive, preferring to pay less when offered the choice.

A New Level With Walmart

Second, Sam Walton applied the exact idea to the discount general store with results that have forever altered the retailing industry. From his book, Sam Walton: Made in America:

Here's the simple lesson we learned...say I bought an item for 80 cents. I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20. I might make only half the profit per item, but because I was selling three times as many, the overall profit was much greater...In retailer language, you can lower your markup but earn more because of increased volume.

The amazing thing to Walton was that this idea was nothing novel. It should have been just as apparent to Kmart and Target (which were founded the same year as Walmart) and other discounters that should have had advantages over the Bentonville upstart. Again, from his book, Walton provides this explanation of why he got the pricing edge: 

What happened was that they didn't really commit to discounting. They held on to their old variety store concepts too long. They were so accustomed to getting their 45 percent markup, they never let go. It was hard for them to take a blouse they'd been selling for $8.00, and sell it for $5.00, and only make 30 percent. With our low costs, our low expense structures, and our low prices, we were ending an era in the heartland. We shut the door on variety store thinking.

The fact that they did not (or could not) adopt the idea even while witnessing Walmart's mind-boggling growth is testimony to how difficult it is for a business to adapt itself to a low-margin model. It seems you must start with the philosophy or you'll just never get it. 

Lesson learned: I don't believe I need to rattle off statistics on Walmart's success using low price as a competitive advantage. Discount shoppers are price sensitive, preferring to pay less when offered the choice. A business that can institutionalize the practices of EDLC-EDLP (see more here) has a competitive advantage over those that cling to high margins when selling the same or similar products. Indeed, the former will move into town eventually and steal market from the latter. History has provided ample evidence of that.

Refined For Home Depot and Costco

Third, unlike all the time that past between A&P demonstrating the earliest success story of the model and Walmart taking it to new heights, contemporaries of Sam Walton gleaned lessons from the concept as they launched their own retail operations. Most notable are Home Depot and Costco. Each has its own twist on the model...

Home Depot does it in categories where Walmart never could compete effectively. It decimated local hardware stores and various home improvement wholesalers in every market it built stores. (You can read the Home Depot story in the founders' book, Built From Scratch. For anyone studying the low price retail model, this book is as important as Sam Walton's.)

And Costco took the idea to its absurd logical extension by somehow intuiting that shoppers would be so enamored of lower prices that they would buy in huge bulk quantities from a much smaller overall selection of goods. Its gross margins are only 11 percent, and its operating expenses are only eight percent of revenue. Contrast that to Walmart's 24 percent and 19 percent performance respective metrics!

(Speaking of Costco, CNBC will be airing its documentary The Costco Craze tonight. If you can't tear yourself away from the NFL Draft, you can click here to see clips and excerpts.) 

Lesson learned: Shoppers are price sensitive in more categories than grocery and discount. They will give their business to the low price seller across a variety of retail lines.

Bringing It To the Web: Amazon.com

Fourth, Amazon.com enters the retail fray with its web only offering in 1994, declaring early that it would stand apart with its selection of goods and its commitment to selling them for less. More about Amazon in the next post.

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In my truncated chronology of retailers using low prices as their form of pricing power as competitive advantage, each iteration built on the lessons provided by its predecessors, tweaking them to fit its particular circumstance and incorporating its own wrinkles for improvement. Amazon is no exception.

The premise is this...

There is an abundance of products and services whose customers possess some degree of price sensitivity. All other variables being equal (or close enough), they will give their business to the low price provider. This price sensitivity creates the potential for shifts in market share.

The companies that commit themselves to being the low price providers in these categories will win additional customers, and often at the direct expense of competitors (though also through increased overall purchasing habits and the general expansion of their market size). They will generate higher sales volume. They will turn inventory more quickly (sales velocity). 

To use terminology from Amazon.com CEO Jeff Bezos, being able to afford selling products and services at low prices means having a lower rate of operating expense. The higher your operating expense, the more you must mark-up your products to generate the gross profits you'll need to cover that overhead. Conversely, when you run a lean operation that squeezes out expenses, you don't require as much gross profit. You can afford to lower your prices.

With lower prices (and each time you lower them further), you initiate a virtuous cycle: lower prices mean high sales volume; higher sales volume means better bargaining power with your suppliers; better bargaining power means lower sourcing costs; and lower sourcing costs means you can afford to lower your prices even further. 

Lather...Rinse...Repeat.

And the virtuous cycle works for equity investors in the businesses. While your net profitability appears low (as a percent of revenue anyway, e.g. Walmart at five percent, Amazon at five percent and Costco at three percent), your return on invested capital is quite high. This is a superior measure of profitability anyway. It means you can generate high earnings against your asset base. It might cost you $10 million to build, equip, and stock a new store, but each store does $50 million in revenue, generates a $12 million in gross profit, has allocated expenses of $9.5 million and so generates $2.5 million of earnings contribution...or 25 percent ROIC on that $10 million initial investment. 

Your sales velocity hits a critical mass in which you're able to sell your inventory more quickly than you pay for it or have to pay your employees for their labor. You obviously pay the bills and paychecks eventually, but as you get a bigger gap between receiving cash and paying it out, it becomes a free source of capital. As long as you keep selling high volumes at high velocities you can use this pile of cash  to invest in your business, make strategic acquisitions, or pay out to shareholders in the form of dividends or share repurchases. 

You could also use it to lower prices even further.

You've created expectations among all your stakeholders that you abide to a low-cost-low-price model. (Indeed, expectations and habits are hard to change. This is probably why so few businesses have ever successfully transitioned from the high-cost-high-price model to low-cost-low-price.) Employees recognize what this means for perks and as a workplace culture. Suppliers know to bring their lowest prices and work with you to make them lower. Customers expect you to have the lowest price and feel less need to comparison shop. And investors come to understand what your model means for them and so gear their expectations accordingly. (Well, theoretically at least.)

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There is a high degree of fanatical devotion to being the low-cost-low-price provider. It has to be this way because there's just a natural tendency to make life easier on the people running the business by raising prices when you're able. For the true devotees, this is heresy. As soon as you look for excuses to raise prices - to cover those growing expenses - you find yourself on a slippery slope.

Walmart protects against it by talking incessantly about the need to keep costs low since the company's founding. From Charles Fishman's bestseller The Wal-Mart Effect:

'Sam valued every penny,' says Ron Loveless, another of Sam's early, legendary store managers...'People say Wal-Mart is making $10 billion a year, or whatever. But that's not how the people inside the company think of it. If you spent a dollar, the question was, How many dollars of merchandise do you have to sell to make that $1? For us, it was $35. So, if you're going to do something that's going to cost Wal-Mart $1 million, you have to sell $35 million in merchandise to make that million.'

Costco talks about being the lowest price provider for every good it sales as a matter of life or death for the business. It's fanatical about maintaining the ability to mark items up only 15 percent, and if it can't sell something for less than the other warehouse clubs or Walmart, it has been known to drop the product altogether...even Coke in this highly publicized price showdown a few years ago.

Amazon is said to leave one empty chair at each meeting as a powerful symbol that the customer is represented in all decisions...always.

These forms of devotion can come across as corny at best and cultish at the extreme. But the madness has a purpose. It reinforces the ideal, creating a culture committed to the idea of low-cost-low-price, spurring workers to pursue it with vigor day-in day-out.

Why? Because it is a competitive advantage. A huge one.

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This essay is meant to weigh the two approaches to pricing power as a competitive business advantage. The first - the ability to raise prices or charge a premium - is not the advantage in and of itself but rather a reflection of an advantage. In the example of Apple, the root advantage is some combination of brand cachet, innovative products, sleek designs, and content that confines purchasing to the iTunes ecosystem. The company has done a remarkable job with this. But I ask the question of what they must continue doing to maintain the advantage. The economics of the business, where revenue is primarily tied to selling more and more products each year, suggest they must stay on the crest of the innovation wave. Constantly. With little to no interruption. If they disappoint their customers with new releases, they risk losing the advantage very quickly to a pack of hungry competitors just a step or two behind.

(Yes, this point - that what Apple does is VERY difficult to sustain - remains just as true today as it was last week when I posted about them...no matter the intervening news about Apple's profit rising 94 percent. I'm not calling an end to Apple's streak of success. I'm remarking how difficult it is to sustain and that one must consider whether it can continue the streak indefinitely and what might happen when the streak does end. Consumer electronics is a TOUGH business.)

The second approach to pricing power - having the ability to lower prices - really is an advantage on its own. Yes, it reflects efficient operations, strong procurement practices, and cultural devotion. But you don't have to provide customers with many reasons to accept your lower prices. If you can do it, a large subset will come to you. 

If you raise prices or continue charging a premium? You must justify it - always - with some benefit that your competition can't match. 

H&R Block (HRB): Entering Shleifer Effect Watchlist

H&R Block (HRB) was slammed this morning after announcing a strategic realignment, using the same press release (here) to announce it also expects fiscal 2012 revenue and earnings to be in line with analyst estimates. The news was a tacit admission that its current approach of offering its services with storefronts and software is far from optimized. With a 13 percent price drop, HRB now sports a P/E around 12 and a dividend yield over five percent.  The dividend looks sustainable from current levels of operating cash flow.

My quick impressions of HRB is that it is a much despised stock with a relatively new management team attempting to escape the reputation established by their predecessors. The business also has a sullied reputation given its long association with tax refund anticipation loans (a practice akin to issuing usurious payday advance loans). Without question, it is in turnaround mode. Its business peaked in 2004 when it generated over $1 billion in operating income, but it was not able to sustain that level of earnings. Earnings have been pretty bumpy ever since. 

This appears to be the first piece of first-order bad news in some time.

Well, we're adding HRB to the Shleifer Watchlist. The next big piece of news seems to be Q4 and FY 2012 earnings announcement that is scheduled for June 26 (see the calendar here). We'll watch with anticipation and try to spend some more time with the business beforehand in case it an overreaction opportunity presents itself.

Walmart (WMT): More Thoughts on NY Times Allegations

As considered here, the allegations of Walmart violating the US Foreign Corrupt Practices Act (FCPA) presents an interesting opportunity to watch the Shleifer Effect in play. 

It's about three days since the news broke. The market reaction has remained pretty tame with Walmart down about 6.5 percent (to about $58) from its Friday close. True, that's $15 or so billion in value disappeared, but that's for a company sporting a $200+ billion market cap. And while it puts WMT near its lows for this calendar year, let's remember that Mr. Market was pretty down on the business just several months ago when it traded below $50 per share. A 6.5 percent drop is big for a single day, but it's not beyond the sort of fluctuating price range most fundamental investors might expect from Mr. Market's typical fickleness.  Per the Shleifer Effect, it doesn't seem to indicate a wholesale change in the way most investors view the business. In other words, it would be hard to argue that the news has stoked an overreaction bias.

When considering the Shleifer Effect, not all news is created equal. Let's say there are two categories of news. You have first order news, the kind that suggests to owners that their thesis for investing might be wrong and a new (negative) trend might be taking hold. This information might say that sales are slipping or expenses increasing or the market is not as strong as hoped or competition has an edge...basically, anything that gives the investor reason to believe the earnings trend points down instead of up. 

First order news is more likely to generate a change in "conservativeness bias", creating a belief in a new trend taking hold, and instigating an overreaction.

I would suggest that first order news is either a.) a story or piece of information that gives the market sufficient reason to believe that earnings will be affected or,  b.) earnings themselves coming in below expectations.

Then there is second order news. While this might be salacious or disturbing, it's ambiguous about how or whether it affects the actual prospects of the business. Investors take notice of it, but they don't necessarily change their views on the prospects of the business itself.

The NY Times story seems to be second order news when it comes to the Shleifer Effect. It has certainly grabbed people's attention, but the market response (so far) suggests investors are willing to wait to see whether the alleged FCPA violations actually affect Walmart's business fundamentals in a meaningful way.

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As a current investor, my initial thoughts on the potential impact of the news are as follows (in order of magnitude):

1. Walmart's International Growth Suffers

Not only will corporate management become entangled in the legal and PR aspects of managing this crisis, but the in-the-trenches guys will be considering their own practices in a different light.

As suggested in this Business Week article (here), Walmart has relied heavily on its international division to produce earnings growth while US performance has been sluggish for a few years. I can easily see a scenario in which international managers go into CYA mode, becoming so conservative in their business practices that they sacrifice growth opportunities. 

Let's hope that the Mexico thing represents the extreme version of international managers pushing the envelope in the name of growth. But I have no doubt that plenty of other managers are aggressive, stepping deep into the gray zone of ethics as they attempt to hit ambitious expansion targets. 

I think it's reasonable to expect that executives throughout the corporation perform a quick review and start slashing practices that might attract any attention from investigators that start poking around, no matter if they're illegal...if it's in the gray zone, it's out. This could affect the number of new store openings, a critical driver of growth.

I don't think we would know anything more about this until we read Walmart's announcements on the performance of its various divisions. So, we wait and see...

2. Walmart's Senior Management Goes Through Widespread Shake-Up

The NY Times article claims that many of Walmart's senior executives were made aware of the activities in Mexico and elected to cover up the problem rather than self-report to the Department of Justice.  It implies CEO Mike Duke, who had management responsibilities over Mexico operations in his role at the time, was briefed on the violations. 

(Somehow Doug MacMillon, current CEO of Walmart International, escaped mention in the article. That's a little baffling especially given his rising star within the company.)

If true, it's hard to see the current regime of executives surviving the investigation. Walmart is under the firm control of the Walton children (who have nearly 50 percent ownership and much more say than all other investors), and I don't see them allowing a wide assault on the reputation of their business without going to the bench to promote a new group of managers.

Expect a shake-up with ensuing disruption. While I'm inclined to want continuity in operations and management (give their strategies a chance to develop), I suspect the Waltons and other investors would not be heart-broken to see the current regime leave. Their performance has not exactly been stellar, most notably when it comes to U.S. same store sales growth, a division that Eduardo Castro-Wright attempted to overhaul after he was promoted from Mexico to run the U.S. (Castro-Wright failed in this attempt and was demoted in 2010 in favor of Bill Simon.) 

The shake-up would likely create optimism for the stock provided Walmart has the right managers in waiting that are both immunized from the scandal and capable up stepping-up.  

3. Walmart Is Punished and Subjected to Historic FCPA Violation Fines

Here is the area where we can expect the greatest speculation. Business Insider has already put together a scenario (here) in which Walmart would have to pay out a fine in excess of $13 billion. 

I have no relevant experience here to make even an educated guess at how this plays out with the DOJ. But I'll try anyway. 

I think it's fair to assume that politics will get nasty and regulators will look for their pound of flesh, hoping to make an example out of Walmart. That being said, it's worth noting that the biggest penalty to date under FCPA has come from Siemen's AG at $1.6 billion. Perhaps Walmart would end up paying higher fines, but I would suspect the DOJ would get what it could and not risk trying to extract such a high penalty that it risks Walmart goes nuclear in fighting back. Would DOJ risk going for something too high and watching Walmart choose litigation over settlement? I would assume they are reasonable and get the guaranteed money for the US Treasury.

Still, what's the effect? First, the process is likely to take a long time (as noted below by Mike Koehler of FCPA Professor in his thoughts here on what we might expect for Walmart's near future as a result of these allegations): 

...the information revealed in the Times article is likely to be a long and costly exercise for Wal-Mart and certain of its executives. Wal-Mart’s statement over the weekend indicated that it already is conducting a world-wide review of its operations and such “where else” investigations frequently uncover additional problematic conduct...This world-wide review will take time and for this reason FCPA scrutiny of the type that Wal-Mart is currently under is likely to last 2-4 years. 

Second, the fine will be a one-time thing. With Walmart losing $15 billion in market value, one could easily argue that investors have already accounted for its penalty (and then some). That's wishful thinking, of course. But with $24 billion in net cash provided by operations last year, we can feel safe that even a large penalty doesn't threaten the ongoing health of Walmart.

It's hard to imagine that a one-time event that might happen two or more years in the future can be properly discounted now. However, when expectations about its price tag get more settled, it is the sort of thing that could create a short-term hit to Walmart's price. We'll watch it then.

*****

And so we call the NY Times story second order news. It puts everyone on alert, and it probably means most investors will be paying a lot more attention to Walmart's earnings announcement over the next several months to see how/if the Mexico scandal is bleeding into operations in a broader way. 

We will continue thinking about our own investment in WMT, watching those earnings carefully to see if they produce a Shleifer Effect overreaction and create another buying opportunity for long-term investors.

Thoughts On Success and Failure

Business Insider posted this today (here).

Not only is the path circuitous, but there is no point to suggest an end to the line. The arrow keeps pointing further (infinitely?) into the future. 

Two things comes to mind. 

First, people interested in developing deep skills in which ever vocation(s) they dedicate their time should spend some serious time with Cal Newport and his "career craftsman" philosophy. We do not stumble into our life's true love, unearthing hidden talent we never knew existed, and make a happy-ever-after career success story. Cal has built a strong case against the do-what-you-love-and-you'll-be-a-success fairy tale, eschewing it for guiding people (as a side gig only, he's a computer science professor) in how to work hard - very hard - to develop deep and narrow skills. 

According to Cal, we make a decision to get good at something. We work hard at it. We work smart at getting better. We carve niches for ourselves. Over years and years of hard work, we develop expertise. And this expertise, along with the hard work itself, can provide deep and abiding satisfaction. And if we're lucky, it provides a means for supporting oneself and the freedom to pursue one's interests as one sees fit.

A reasonable person might call that outcome success.

But, second, what is success? Is it really an outcome? Too often we think of it as a destination as if it were a platform we land on and upon which we reside forever more. I think we would find that most people we consider successful don't think of it as such a static thing. It's very dynamic. And it's not accurate to use the term in such a general way. I would argue it's just not a precise use of the term.

Perhaps you accomplished a specific thing successfully. You employed strong thinking in an investment decision process that produced an outcome with high returns. That was an example of being successful, but does it define you as a "success." Or say you produced a string of these good outcomes with high returns. Again, those are multiple instances of success, but are you now a "success?" 

You can have a thousand such "successes" followed by a single "failure." How are you then labeled? Or you have a thousand failures followed by a single success. 

Such labels are meaningless. I'm reminded of Malcolm Gladwell's New Yorker profile of Nassim Taleb several years ago. (Click here to read Blowing Up: How Nassim Taleb Turned the Inevitability of Disaster Into an Investment Strategy.) Taleb revered Victor Niederhoffer as one of the world's best traders and a brilliant thinker. Niederhoffer had a respected fund with investors desperate to include their capital in his investments. He had more wealth than most people could hope for. 

Niederhoffer had it all. Until he didn't. He "blew up", as traders put it, when the strategy he had used with such success for a decade suddenly didn't work. He lost everything. One day he was a "success" and the next he was a "failure." Well, that would be the description if you chose to think of it in such "destination" terms.   

It all brings to mind the story of the Taoist farmer. I had a vague recollection of the tale, and googling it produced this version (from this source):

This farmer had only one horse, and one day the horse ran away. The neighbors came to condole over his terrible loss. The farmer said, "What makes you think it is so terrible?"

A month later, the horse came home--this time bringing with her two beautiful wild horses. The neighbors became excited at the farmer's good fortune. Such lovely strong horses! The farmer said, "What makes you think this is good fortune?"

The farmer's son was thrown from one of the wild horses and broke his leg. All the neighbors were very distressed. Such bad luck! The farmer said, "What makes you think it is bad?"

A war came, and every able-bodied man was conscripted and sent into battle. Only the farmer's son, because he had a broken leg, remained. The neighbors congratulated the farmer. "What makes you think this is good?" said the farmer.

Luck is fleeting. It is a point-in-time result. What we perceive as luck today, we may view as the root of great misfortune tomorrow. The same reasons we might have used to consider a person lucky today we might use to pity him tomorrow.

So goes success, and so the path is circuitous and the arrow points forever further.