Is Asset Picking an Asset?

On 15th March 2018 by good2us

CEOs come in all shapes and sizes. Some are polishers who focus on product improvement and design in a quest for perfection. Pickers, by contrast, are capital allocators, who stand back and decide unsentimentally how the firm should deploy resources. But do pickers polish off polishers?

Jeff Immelt, who runs General Electric (GE), the world’s most valuable industrial firm is a ‘picker’. Since taking over in 2001 his record shows that capital allocation is far harder than might be thought.

Irrespective of whether CEOs see themselves as ‘pickers’ like Steve Jobs, obsessed with “the finish on a piece of metal, the curve of the head of a screw, the shade of blue on a box”, they end up ‘pickers’, since capital allocation is what a CEO does, like it or not.

If a firm that reinvests 10% of its net worth every year then by the tenth year in charge the CEO’s choices about deploying cash will explain 60% of the firm’s book value.

Taking firm control of the process makes obvious sense. In the 1970s the logic of starving lousy businesses and feeding good ones was spread by management-consulting firms. The Boston Consulting Group (BCG) told firms to split portfolios into four buckets: cash cows worth milking, stars, dogs that should be shot and question-marks.

Today the consultancy reckons that businesses shift between the buckets twice as fast as they did in the 1990s.

Jeff Immelt has remade GE partly because what he inherited had problems. GE’s shares were overvalued, its earnings were inflated by gains from its pension scheme, and it had over expanded its financial arm, which later blew up during the banking crisis. He has globalised GE: 57% of sales now come from abroad, up from 29% in 2001. And he has loosened up its culture. Its old head office, in Connecticut, sat amid suburbs and golf courses. It moved to Boston, next to an art institute.

As a ‘picker’ and an allocator of capital allocator, he shrunk or sold businesses that were mature or under margin pressure, such as plastics and kitchen appliances, or where GE has no advantage, such as media. He killed off most of its financial arm. And he has bought in areas with promising growth stories where tech is becoming more important, such as aviation, power systems and medical devices.

The scale of change has been huge. Outside the financial arm, looking just at industrial operations, since 2001 GE has traded businesses worth $126bn, or 167% of the capital employed in its industrial divisions. Including capital expenditures, Jeff Immelt has redirected resources worth a colossal 227% of GE’s capital base.

gealloc

However, the results are less impressive. Annual free cashflow from GE’s industrial business was around $10bn in 2001 and the figure has not risen even as its capital employed has increased from below $30bn to $75bn (see chart). Cash returns on capital have fallen to about 12%. Partly reflecting this, GE’s shares have lagged behind the S&P 500 index over most periods.

Despite being a logical strategy, methodically implemented by competent people, it has not performed as might be expected. Active capital allocation carries a danger: it can be pro-cyclical, magnifying the swings in sentiment that most industries face. Businesses that are performing well often have profits that are at cyclical highs and that are valued at inflated levels.

It is perhaps instructive to note that eight bosses whose firms on average have outpaced the S&P 500 by a factor of 20 may have been obsessed with capital allocation, but they bought into deeply unfashionable things. These included decrepit cable-TV networks in rural America (John Malone at TCI), to the makers of Twinkies (Bill Stiritz at Ralston Purina).

Bucking accepted wisdom is, however, extraordinarily hard for CEOs of big, iconic firms, who must built a consensus among executives, directors and shareholders..

The cost of churning capital in predictable ways can be significant. GE may have paid 13 times gross operating profits for the businesses it has bought and got 9 times for those it sold. Some nine-tenths of its industrial capital is now comprised of goodwill, or the premium that a firm paid above book value for its acquisitions. A company’s capital expenditure can also be pro-cyclical. For example, in 2010-14 GE ramped up investment in its oil and gas business, at a point when energy prices were high, then cut back after they slumped in 2015.

There are, overall, benefits to be gained from churning portfolios. Firms must respond to changes in customer tastes and technology. They may be able to boost their market shares for some products, allowing them to raise prices. But it seems unlikely that hyperactive capital allocation greatly enhances wealth overall.

Deals are often a zero-sum game. It is impossible for every firm to own only outperforming businesses. And the fees lawyers and bankers charge are a tax on corporate activity that corrodes value.

However, all is not lost. GE’s profits are rising even as its cash flows stall, as it books the gains it expects to make on long-term infrastructure projects and servicing contracts. It has launched a new jet engine, called Leap, and is investing heavily in Predix, an open data platform that it hopes will become an operating base for a host of industrial digital applications. And it is buying new assets at the bottom of the cycle, with a planned merger of its energy business with Baker Hughes, an oil-services firm. Pressure is likely to mount soon to be ‘picky’ again and undertake another massive reshuffle of what GE owns. It may well be time to ‘polish’ existing assets rather than ‘pick’ new ones.

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