why commodities companies overinvest, turning boom to bust

This is a continuation of my post from yesterday.

It may be that, as Chris Hackett suggests in a comment to yesterday’s post, that everyone has his head in the sand, not only commodities company CEOs and boards.  Maybe it’s some deep-seated psychological need to have the good times continue, or maybe a denial of the finitude of man, or…  Yes, commodities companies aren’t the only ones who extrapolate chiefly from the recent past in forecasting the future.  Nevertheless, I can think of three reasons why commodities companies feel most comfortable reinvesting cyclical cash windfalls back into new capacity in their primary business–even though that action itself inevitably triggers a cyclical downturn.

1.. It may be the best they can do.

Looking back at yesterday’s post, I think I was a little unfair in saying that there firms never think of diversifying.  During the first oil crisis in the early 1970s, all the big oils did diversify.  Gulf Oil bought the Barnum and Bailey circus (great job, Gulf; no wonder you got taken over); Mobil bought Montgomery Ward and Container Corp of America (both disasters); Exxon started a venture capital arm, which produced nothing of note.

Peter Lynch, of Fidelity fame, called this kind of move “diworsification.”  Ugly word, but an accurate observation.  Look at HPQ or Microsoft as other serial diworsifiers.

Of course, this is not really the best a company can do, either.  The firm could pay a special dividend to shareholders, but this sensible action rarely occurs to CEOs.  Reinvesting in a business they has some expertise in always seems to be the safest bet.

2.  Holding on to cash may be personally risky to a CEO, for two reasons:

–a cash hoard may make the company a takeover target.  Great for shareholders, not so much for the ego of a person who’s a demi-god to employees, but just a broken down old guy (albeit a rich one) if he loses his position.

–a sensible strategy would be to amass cash with the intention of buying assets on the cheap from semi-bankrupt competitors a couple of years after the cycle turns.  Suppose the cycle lasts longer than the CEO expects, however.  His profits are less than competitors; his company’s stock underperforms.  Maybe he’s ousted before he can act and his successor reaps the glory of making canny acquisitions.

Arguably you have more job security by staying with the herd.

3.  I can believe that adding capacity at or near the top of the cycle can make a perverse kind of sense under three (or maybe four) conditions.  They are the assumptions that:

–all attempts to diversify into other businesses will end in disaster,

–the company’s industry is in secular expansion, so that new capacity will be very valuable in the next upcycle,

–the company will be the first to add significant capacity, and will therefore have a year or two of supernormal profits from the new plant.   That will ease the pain of the downturn and put the firm in a stronger market position in the next upturn.

–(the, maybe, fourth)  even if a firm can’t be alone as the first to add new capacity, it should expand anyway.  This extra industry capacity will at least foil rivals’ plans to cash in big with their expansions.  Yes, the downturn will come earlier than otherwise, but the present market structure will be preserved.  A bit Machiavellian, and maybe giving undue credit to guys who think buying the circus is a great idea.  But it’s possible.

My bottom line:  long-cycle commodities, epitomized by base metals mining, are a true boom and bust industry.  As such, they’re a value investor’s dream come true.  For the rest of us, if we want to play we have to be in the uncomfortable position of buying when the stocks are very beaten down and it seems all hope is lost.  If you’re not accustomed to thinking this way, picking the right point to buy will be very difficult.  In any event, that point is not today.

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