The Price of Growth

By Rob Landley (landley@flash.net)

AUSTIN, TX (Feb. 17, 1999) -- First off, it's my pleasure to announce that we purchased 16 shares of Yahoo! (Nasdaq: YHOO) this afternoon at $125.8125 per share. We also paid $7.95 in commission. To reiterate, that's real money, in a real discount brokerage account. To read why we bought Yahoo! for the Rule Maker portfolio, click here. We'll keep a close eye on Yahoo! as we hold the company over the next five to ten years.

Today, I want to talk about a book I recently read called Liar's Poker by Michael Lewis. It chronicles the rise and fall of Salomon Brothers during the 1980s and is chock-full of lessons for Fools. I highly recommend it.

First of all, as a behind-the-scenes account of what really goes on at a brokerage, it reinforces our longstanding conviction that the salesman selling you investment products isn't on your side anymore than the salesman selling you a used car. This book goes into graphic detail on the topic (and contains some graphic language quoted from the trading floor). There's also some interesting history about the savings and loan crisis and a broker's-eye view of the 1987 stock market crash.

But the real story in the book is what happened to Salomon Brothers as a company -- how uncontrolled success can lead straight to failure. This is what I want to talk about today.

Salomon was a brokerage house that specialized in trading bonds rather than stocks; a fairly uninteresting niche until a sudden change in Federal Reserve policy. In 1979, the Fed decided to switch the primary tool it used to influence the economy. Instead of increasing or shrinking the money supply, it would now move interest rates around to encourage or discourage economic activity in hopes of keeping inflation under control.

Suddenly, with interest rates changing every few months, the ultimate value of long-term bonds at maturity started fluctuating wildly. Speculators willing to guess where interest rates were headed descended on this new playground and day trading in bonds was born. And the only place really set up to handle high volume bond trading was Salomon Brothers. Salomon had a huge head start in this new market, and the commissions just poured in.

Around the same time, a group of Salomon traders were figuring out how to package home mortgages together into tradable bonds. It took years to work out the technical and legal aspects (read the book), but today mortgage bonds are big business, and Salomon Brothers invented it and kept a monopoly on it for years. With no competition and customers who took a while to figure out how to properly value their investments, Salomon Brothers mortgage bond traders spent years raking in commissions as fast as they could pick up their phones.

With virtually unlimited funds and dozens of times more business than it could handle, Salomon Brothers went on a hiring binge. It scooped up new employees, built new offices around the world, swelled up like an over-inflated balloon, and finally tore itself apart.

Growth is probably the hardest thing a company can do. When a company doubles in size, half of it is brand new and wasn't a part of the success that allowed the company to grow in the first place. It's unpolished, untested, and requires time and effort to work out the kinks. That's assuming it makes it that far.

When a garage-run start-up grows too large for its founder to personally manage, a whole new set of skills is required to deal with the situation. The founder must learn to delegate authority and find skilled new managers to delegate that authority to. The founder must recognize that delegation is required and have the humility to identify herself as a bottleneck. This is one reason so many initially successful start-ups fail: the strain of growth on management.

The company must also find new employees to do the actual work, and train them in the skills required to perform the jobs the business needs to get done. This is very hard, too: employees are not interchangeable cogs, no matter how much management would like them to be. Also, good employees may not make good teachers. Inexperience, personality conflicts, dishonesty, incompetence, and general stupidity are just some of the land mines in the way of a business trying to make new employees as productive as seasoned veterans.

Worst of all, what happens when the founder leaves, the suits take over, and the veteran employees find themselves surrounded by newly hired strangers on all sides? If the cozy little family they used to work for no longer exists, why stick around? Veterans have valuable, marketable skills other companies are probably drooling over. They may have stock options issued in lieu of cash when the company couldn't afford to pay them what they were worth, which are now worth millions. They may simply have saved enough money to retire. With the company paying so much attention to the new employees, the veterans are likely to walk.

Often the company's FOUNDER leaves, as happened to Apple and Lotus. The new part of the company takes over from the old, and things like "vision," "innovation," and "leadership" have no part in a company based on inventory regulation and the bottom line of the balance sheet. This is often a very bad sign.

Successfully handling growth requires its own set of skills. One reason we like Rule Makers is that they've proven their ability to grow, and the ability to regulate that growth so they don't get themselves in trouble. Salomon Brothers didn't have that: it got drunk with success and woke up with a bad hangover. The new people drove out the old, management lost touch, corporate loyalty disappeared, and when the competition finally caught up and ate into Salomon's business, it collapsed into rubble.

Eventually, the nation's leading authority on how to run a business, Warren Buffett, was persuaded to come in and clean up the mess (as detailed in the biographical Buffett: The Making of an American Capitalist by Roger Lowenstein -- another EXCELLENT book.) But by then, Salomon Brothers was a complete wreck.

The moral of the story is that we'll be watching Yahoo! It's been around longer than any other Internet company I can think of, it's the veteran of its field, and we believe it's the best bet out of all the Internet stocks. It's done a lot of growing already, but still has to pull off a lot more just to justify the price we're buying in at, let alone the glorious future we see for it. And growth is a hard thing that, by definition, changes a company.

- Oak

02/17/99 Close

Stock  Change    Bid
AXP   +  9/16  102.75
CHV   -2 1/8   77.38
CSCO  -3 15/16 95.13
KO    -  9/16  64.31
GPS   +1 1/8   62.63
EK    -  11/16 64.31
XON   +  1/16  68.63
GM    -  1/2   82.56
INTC  -1 5/8   124.63
MSFT  -6 3/16  150.06
PFE   -  13/16 130.00
SGP   -  7/16  54.31
TROW  -  9/16  30.44
YHOO  -3 3/4   129.63
                   Day   Month    Year  History
        R-MAKER  -1.22%  -5.96%   1.97%  29.03%
        S&P:     -1.43%  -4.34%  -0.10%  23.66%
        NASDAQ:  -2.81% -10.25%   2.56%  36.06%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    150.06    91.73%
    5/1/98   55 Gap Inc.      34.37     62.63    82.21%
   6/23/98   34 Cisco Syst    58.41     95.13    62.86%
    2/3/98   22 Pfizer        82.30    130.00    57.96%
   2/13/98   22 Intel         84.67    124.63    47.18%
   8/21/98   44 Schering-P    47.99     54.31    13.17%
   5/26/98   18 AmExpress    104.07    102.75    -1.27%
   2/27/98   27 Coca-Cola     69.11     64.31    -6.94%
    2/6/98   56 T. Rowe Pr    33.67     30.44    -9.61%
   2/17/99   16 Yahoo Inc.   125.81    129.63     3.03%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     68.63     6.67%
   3/12/98   20 Eastman Ko    63.15     64.31     1.84%
   3/12/98   15 Chevron       83.34     77.38    -7.16%
   3/12/98   17 General Mo    72.41     82.56    14.03%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   3601.50  $1723.05
    5/1/98   55 Gap Inc.    1890.33   3444.38  $1554.05
   6/23/98   34 Cisco Syst  1985.95   3234.25  $1248.30
    2/3/98   22 Pfizer      1810.58   2860.00  $1049.42
   2/13/98   22 Intel       1862.83   2741.75   $878.92
   8/21/98   44 Schering-P   2111.7   2389.75   $278.05
   5/26/98   18 AmExpress   1873.20   1849.50   -$23.70
   2/27/98   27 Coca-Cola   1865.89   1736.44  -$129.45
    2/6/98   56 T. Rowe Pr  1885.70   1704.50  -$181.20
   2/17/99   16 Yahoo Inc.  2013.00   2074.00    $61.00

Foolish Four Stocks
    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Eastman Ko  1262.95   1286.25    $23.30
   3/12/98   15 Chevron     1250.14   1160.63   -$89.52
   3/12/98   20 Exxon       1286.70   1372.50    $85.80
   3/12/98   17 General Mo  1230.89   1403.56   $172.67

                              CASH    $185.03
                             TOTAL  $31044.03

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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