I saw an interesting interview with Bose Corporation's founder, Amar Bose. Bose is best known for its well-engineered audio products, including speakers, amplifiers, and stereo systems. But Bose has recently turned its eyes toward the automotive industry, putting out suspension products that it claims are superior to anything else on the market.
Now usually when a public company suddenly shifts and says, "well, we've always been a restaurant management company, but now we're going into ball bearings!," investors run for the hills. The reason is that there is a long and enduring history of companies diversifying their product or business offerings for the sake of keeping up the growth story once their core businesses become saturated. This rarely ends well, but since investors tend to reward "growth" companies with higher multiples than ones that have much slower-rising top lines, the incentive to do so remains almost irresistible.
This is the very reason I love public companies that are run as if they were private. No, not in the "this company is my baby and my private piggy bank" way that was evident at companies like Adelphia, Parmalat, and Friedman's, and not when the majority shareholder holds a whole host of "related party" businesses, which makes shenanigans almost too easy to pull.
25 years of red ink, willingly undertaken
Back to Bose, when I say "recently turned its eyes," I suspect that I should clarify the word "recent." Amar Bose, along with being an audiophile, is a bit of a gearhead. So in 1980 he began trying to solve the mathematics of a suspension system for cars, hiring people in earnest for the project in 1985. According to the company's research, the system allows a Lexus LS400 to handle better than a stock-equipped Porsche 911, which is an engineering marvel in its own right. Bose is now seeking a manufacturer to adopt its system, which means that it has yet to make a penny on the project.
Got that? Bose has funded a research and development project 25 years in the making, completely external to its core business, the expense for which has driven Bose's CFO "crazy." What has come out at the end is a technology that could transform the auto business, but the risk has been huge. Mr. Bose points out something more, though: He doubts that publicly traded companies could even do a project like this, since they are beholden to shareholders who scrutinize their performance every 90 days.
Were Bose a public company, it would have had to answer for its expenditures on this auto suspension project almost 100 times -- four times per year for 25 years. And it would have had to say the same thing each time: "this is a long-term project, the outcome of which is uncertain, but we believe that the reward for success is massive." What the heck kind of a pig-in-a-poke is that? Investors deeply wedded to that magical 15% per year growth in earnings shibboleth wouldn't stand for it. Bose would be valued at much less than its peers due to lumpy earnings, uncertainty, and a management prone to chasing rabbits for a quarter century with no payoff. And for many companies, that reduced per share value would be simply untenable, and so they'd make decisions with the next quarter, or the next year's results in mind, even if it were at the expense of a great long-term project.
I'm not saying that Bose's suspension system with its unbroken string of 25 years of losses is the right thing to do; with each unit costing a projected $20,000, it is conceivable that Bose will never generate enough volume sales to justify the expense of development. What I am saying is that public companies that have their eyes constantly on their share prices have no chance and plenty of disincentives from doing long-term capital projects. In this regard, the monomaniacal focus you see at many companies in meeting their numbers, or showing consistent, steady growth, provides advantages to companies that don't have this focus or problem.
Whatever you do, don't cut the M&M's budget
Many of the companies in the latter category are private. You think Jim Goodnight, the sole shareholder of software giant SAS Institute, gives a rip that quarterly earnings at his company are smooth and predictable? Not if it means cutting back on promising new research, he doesn't. Not even if it means cutting out the nearly 30 tons of M&M's SAS buys every year (from Mars, another private company) to keep its employees happy. Being private means that you can do things because they make sense, not because they look good on a quarterly ledger. Read this 1999 article on SAS from Fast Company. Rest assured, little has changed since the market's swoon.
As another example, one of the fastest-growing retailers in America is Crate & Barrel, with its 130 home furnishings and housewares stores spanning from coast to coast. Crate & Barrel is private, and its founder, Gordon Segal, intends to keep it that way. In fact, he believes, as Amar Bose does, that being private is an advantage. If Crate & Barrel doesn't see attractive locations to open stores at cost structures that make sense, it doesn't open any.
This, of course, would be disaster for a company that has promised uninterrupted growth to investors, and since CEOs at America's public companies have an average length of employment of four years, such a disappointment would be greatly unacceptable to their personal bank accounts. So they press and open new stores, or they cancel promising research projects that would take too long to show any returns, or they go out and make acquisitions and buy the growth that they cannot create in house. All of this makes Wall Street happy, but the opportunity cost of such decisions can be enormous. So why can't public companies act like they're private? Sadly, because the very flexibility that makes private companies great is completely devalued by Wall Street in favor of predictability and consistency, especially when it comes to growth.
Need an example? Well, there's Lucent (NYSE:LU), which at the end of the telecom-building binge started giving extraordinary financing terms to companies that had no standing upon which to get financing, most notably now-bankrupt Winstar. Once the growth engine faltered, the damage the company had done to its balance sheet chasing that growth came back to haunt it. More recently a similar thing happened with Krispy Kreme (NYSE:KKD).
When Krispy Kreme was private, it opened shops conservatively, as opportunities arose. Once it came public, former CEO Scott Livengood flogged the company nearly to death in order to ensure that shareholders got the growth story they expected, lest the company's shares get hammered. The only imperative that management heeded was the imperative to deliver double-digit growth. The end result has been a disaster.
It isn't always this way, but whenever I hear of a manager targeting that magic 15% growth level the hot money requires, like Newell Rubbermaid's (NYSE:NWL) Joe Galli did soon after he arrived at the company, I immediately wonder what laws of physics are going to be broken in order to meet the challenge.
There are plenty of companies that resist this institutional imperative: At the top of the list, of course, is Berkshire Hathaway (NYSE:BRKa). In its insurance businesses, Warren Buffett's group refuses to fire underwriters for not writing policies in a bad market; they would rather pay their employees to sit idle for a time than create an environment where the employees feel pressure to keep their sales volume levels up. Buffett runs Berkshire as if it were private. Other companies that I believe fit this model include Annaly Mortgage (NYSE:NLY), Leucadia (NYSE:LUK), Fastenal (NASDAQ:FAST), and Costco (NASDAQ:COST).
Interestingly, plenty of Berkshire subsidiaries and investees fall into this same camp. For example, Jordan's Furniture, a Berkshire subsidiary, once shut down for the day so the Tatelman brothers, the founders of the company, could fly the employees -- stock clerks, janitors, everyone -- on a day trip to Bermuda as a thank you. What was the cost of the trip in terms of lost revenues? Ask Buffett, ask the Tatelmans and you'd likely hear the same thing: "Dunno. It was worth it."
The danger, of course, is that private companies are not necessarily operated efficiently, and public companies that work like private ones could offer the worst of both worlds, not the best. Acting private, after all, means acting the same as if you had no minority shareholders -- in effect, you have to ignore what they want. I suggest that the difference is this: A positive manifestation is when management cares enough about shareholders that it focuses on what it believes is in their best interest, while the negative manifestation is when management ignores shareholders because it neither has their best interests at heart nor cares what they want at all. Is this just semantics? Well, yeah, but figuring out what kind of management you're dealing with can make all the difference in the world.
Want to find out some of the tip-offs of poor management? Read Bill Mann's "Welcome to the Machine."
Bill Mann owns shares of Costco, Annaly Mortgage, and Berkshire Hathaway. The Motley Fool is investors writing for investors.
