This post should end the series, at least for now. Tonight I want to talk about the limits to compounding growth. Drawing from an old article of mine freely available at TSCM, I quote the following regarding talking to management teams:
What single constraint on the profitable growth of your enterprise would you eliminate if you could?
Companies tend to grow very rapidly until they run into something that constrains their growth. Common constraints are:
- insufficient demand at current prices
- insufficient talent for some critical labor resource at current prices
- insufficient supply from some critical resource supplier at current prices (the “commodity” in question could be iron ore, unionized labor contracts, etc.)
- insufficient fixed capital (e.g., “We would refine more oil if we could, but our refineries are already running at 102% of rated capacity. We would build another refinery if we could, but we’re just not sure we could get the permits. Even if we could get the permits, we wonder if long-term pricing would make it profitable.”)
- insufficient financial capital (e.g., “We’re opening new stores as fast as we can, but we don’t feel that it is prudent to borrow more at present, and raising equity would dilute current shareholders.”)
There are more, but you get the idea.
Again, the intelligent analyst has a reasonable idea of the answer before he asks the question. Part of the exercise is testing how businesslike management is, with the opportunity to learn something new in terms of the difficulties that a management team faces in raising profits.
As with biological processes, when there are unlimited resources, and no predators, growth of populations is exponential. But there are limits to business and investment profits because of competition for customers or suppliers, and good untried ideas are scarce. Once a company has saturated its markets, it needs a new highly successful product to keep the growth up. Perhaps international expansion will work, or maybe not? Are there new marketing channels, alternative uses, etc?
Trying to maintain a consistently high return on equity [ROE] over a long period of time is a fools bargain and I’ll use an anecdote from a company I know well, AIG. I was pricing a new annuity product for AIG, and I noticed the pattern for the ROE of the product was not linear — it fell through the surrender charge period, and then jumped to a high level after the surrender charge period was over.
I scratched my head, and said “How can I make a decision off of that?” I decided to create a new measure called constant return on equity [CROE], where I adjusted for capital employed, and calculated the internal rate of return of the free cash flows. I.e., what were we earning on capital, on average over the life of the product.
I took it to my higher-ups, hoping they would be pleased, and one said, “You don’t get it! You don’t argue with Moses! The commandment around here is a 15% return on average equity after-tax! I don’t care about your new measure! Does it give us a 15% return on average equity or not?!”
This person did not care for nuances, but I tried to explain the ROE pattern, and how this measure averaged it out. It did not fly. As many have commented, AIG was not a place that prized actuaries, particularly ones with principles.
As it was AIG found ways to keep its ROE high:
- Exotic markets.
- Be in every country.
- Be in every market in the US.
- Play sharp with reinsurers.
- Increase leverage
- Press the accounting hard, including finite reinsurance and other distortions of accounting.
- Treat credit default swap premiums as “found money.”
- Take on additional credit risk, like subprime lending inside the life companies through securities lending.
In the end, it was a mess, and destroyed what could have been a really good company. Now, it won’t pay back the government in full, much less provide anything to its shareholders, common and preferred.
Even a company that is clever about acquisitions, like Assurant, where they do little tuck-in acquisitions and grow them organically, will eventually fall prey to the limits of their own growth. That won’t happen for a while there, but for any company, it is something to watch. Consistently high growth requires consistently increasing innovation, and that is really hard to do as the assets grow.
If True of Companies, More True of Governments
This is not only true of companies, but even nations. After a long boom period, state and federal governments stopped treating growth in asset values as a birthright, granting them a seemingly unlimited stream of taxes from capital gains, property, and transfer taxes. They took it a step further, borrowing in the present because they knew they would have more taxes later. The states, most of which had to run a balanced budget, cheated in a different way — they didn’t lay aside enough cash for their pension and retiree healthcare promises. The Federal government did both — borrowing and underfunding, because tomorrow will always be better than today.
Over a long enough period of time, things will be better in the future, absent plague, famine, rampant socialism, or war on your home soil. But when a government makes long-dated promises, the future has to be better by a certain amount, and if not, there will be trouble. That’s why an economic downturn is so costly now, the dogs are behind the rabbit already, running backwards while the rabbit moves forwards makes it that much harder to catch up.
I’ve often said that observed economic relationships stop working when people start relying on them, or, start borrowing against them. The system shifts in order to eliminate the “free lunch” that many thought was available.
A Final Note
Hedge funds and other aggressive investment vehicles should take note. Just as it is impossible for corporations to compound their high profits for many decades, it is impossible to do the same as an investor. Size catches up with you. It’s a lot easier to manage a smaller amount — there are only so many opportunities and inefficiencies, and even fewer when you have to do so in size, like Mr. Buffett has to do.
“No tree grows to the sky.” Wise words worth taking to heart. Investment, Corporate, and Economic systems have limits in the intermediate-term. Wise investors respect those limits, and look for growth in medium-sized and smaller institutions, not the growth heroes of the past, which are behemoths now.
As for governments, be skeptical of the ability of governments to “do it all,” being a savior for every problem. Their resources are more limited than most would think. Also, look at the retreat in housing prices, because the retreat there is a display of what is happening to tax revenues… the dearth will last as long.
Full disclosure: long AIZ