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The Great American (Ponzi) Scheme - Capital Intensive Businesses and Diminishing Returns
Posted by: Tannor Pilatzke (IP Logged)
Date: November 26, 2013 09:40AM

“A growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years.”Warren Buffett

(I will do this experiment after my finals and post an article to follow.)

Above was a small discussion from Warren Buffett in one of his annual letters to shareholders about the pitfalls of investing in yesterday’s winners. This article is based from the small excerpt from John Train's “The Money Masters” under the first chapter on Warren Buffett, the final entry being “The Great American Jam Tomorrow Ponzi Scheme.”

Buffet explained in 1980 that a large portion of American enterprises are at risk and investors should stay clear of them, based on the massive investment that they will have to make. The cause of the large investments these companies must make is regulation, competition, rising labor costs, globalization, pursuit of productivity improvements, higher obsolescence rates than depreciation, etc.

Essentially, these companies need endless amounts of (net) new cash, and of course, this (net) new cash offers interest and dividend payments in the mean time to induce investors to continually partake in the illusory party. Dividends are continually increased to push equity prices higher then further secondary offers commence to pay for additional capex and dividend liabilities, diluting shareholders and ending in most cases with an eventual dividend cut. Other wise investors will continually stake money in mandatory rights offerings to continue to own the same percentage of the company. The chances investors ever actually see their (full) capital returned is slim, let alone with a satisfactory return, either due to dilution, bankruptcy, or take-overs below investors average costs.

Buffett described this process in a simple phrase, “Jam yesterday and jam tomorrow, but never jam today." Companies that continually issue bonds or offer equity, while paying a dividend or are simply net users of cash (after honest depreciation plus competitive capex) and never actually provide net cash over long periods of time, could be classified as a Ponzi scheme. These companies have an obsolescence rate that is faster than their allowable depreciation, thus creating bottomless capex pits.

Buffett uses an example of Ford Motor Company (in 1980): “Ford doesn’t ordinarily pay enough dividends to give its own shareholders after taxes, the equivalent of 100,000 cars a year out of the 6-odd million that it makes. All that money, that huge plant, those many generations, and still the impact of higher costs, taxes and foreign competition mean that the owners can’t even claim 2% of the output.”

These companies need to retain earnings continually to pay for improvements and new plants, machinery, equipment, etc. Like most of us would know and agree, compounding capital or interest can work in the opposite direction, although asymmetrically (meaning a 50% loss must be made up by a 100% gain).

The key here is increasing your purchasing power in real terms, not absolute values. Buffett provided another three examples of capital-intensive businesses in “heavy” industries. The examples were AT&T, American Airlines and General Motors (ironically GM he now owns).

AT&T can be classified in the “ratchet up” dividend-equity offering strategy outlined above, coupled with large bond offering to finance capex, acquisitions and dividends. General Motors is a similar example to the Ford example provided; scroll up for a refresher.

In regard to American Airlines, Buffett mentioned it only turns its capital (including leased equipment and facilities) once a year. He said on that basis it would need to realize close to 20% pre-tax profit margins on sales in order to net 10% if financed by equity capital. This would put American Airlines at the time at the top of the industry for pre-tax profit margins. (It has gone bankrupt in the mean time and is planning to to exit after a recent federal judge approval).

Buffett when talking to an executive of a capital-intensive business (anonymous) asked, “Why don’t you buy back your own stock? If you like to buy new facilities at one hundred cents on the dollar, why not buy the ones you know best and were responsible for creating twenty-five cents on the dollar?"

The executive responded, “We should.”
Buffett: “Well?”
Executive: “That’s not what we’re here to do.”

He didn’t buy the stock.



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Re The Great American Ponzi Scheme - Capital Intensive Businesses and Diminishing Returns
Posted by: 20punches (IP Logged)
Date: November 27, 2013 03:58PM

Hi Tannor, thanks for a great article. I was wondering whether you have looked further into how Buffett calculates the following numbers: 20% 10%, 100000 cars and 2%. "In regard to American Airlines, Buffett mentioned it only turns its capital (including leased equipment and facilities) once a year. He said on that basis it would need to realize close to 20% pre-tax profit margins on sales in order to net 10% if financed by equity capital. " “Ford doesn’t ordinarily pay enough dividends to give its own shareholders after taxes, the equivalent of 100,000 cars a year out of the 6-odd million that it makes. All that money, that huge plant, those many generations, and still the impact of higher costs, taxes and foreign competition mean that the owners can’t even claim 2% of the output.”


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Re The Great American Ponzi Scheme - Capital Intensive Businesses and Diminishing Returns
Posted by: mpheny (IP Logged)
Date: November 27, 2013 08:08PM

Your article really adds no real value and while I understand you are trying to get some exposure and note your ambitions, please spare the rest of us from your quest.


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Re The Great American Ponzi Scheme - Capital Intensive Businesses and Diminishing Returns
Posted by: TannorP@twitter (IP Logged)
Date: November 27, 2013 09:31PM

Thanks Ning Jia,

I have looked into the numbers of Ford over the years, I did not actually calculate the numbers, back checking Buffett from his statements. I have never looked into the numbers around any airline for any length of time, other than a Southwest case study in school. I think what Buffett was addressing in the article about Ford was the after tax income available to shareholders over a long period of time.

2002-2012 Cumulative Revenue was 1.5068 Trillion compared to 10 Billion net income, -14.9B without continuing operations additions, 105.16B in depreciation, 3.435 Billion in dividends while 100% dilution occurred over the 10 years. 37.4B PPE + 75B working capital (2012) to produce 134B sales, just over 1.15 turns. 1.5068 Trillion / 3.435 Billion = 0.015% add in retained earnings 20.4B = 2.38% available for distribution or has been distributed (10-year gross average)

Anyway, Buffett is clearly a lot better at analyzing businesses than I am. I have no clue how he came to the numbers of American Airlines (the effective corporate tax rate was not 50%) nor do I understand the relationship to "if financed by equity capital" without a specific number. I would be happy to hear from others if they see the picture more clearly. Hope I helped, as that is my only intention.

Cheers,


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Re The Great American Ponzi Scheme - Capital Intensive Businesses and Diminishing Returns
Posted by: TannorP@twitter (IP Logged)
Date: November 27, 2013 10:09PM

Mpheny,

I am sorry that you feel that way and wish I could of provided more value for you. Is there anything in particular A) I can do to improve on my deficiencies and B) focus on that would be more of value to someone like yourself.

I am not trying to gain exposure at all rather help educate and share my knowledge while learning from others with a similar mind set. In regards to ambitions, yes I have them, no I don't care if other people notice. You are more than welcome to quit the "quest" or simply not join, I for one will not be quitting as I am on a never ending quest for knowledge.

Cheers,


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Re The Great American Ponzi Scheme - Capital Intensive Businesses and Diminishing Returns
Posted by: jk815 (IP Logged)
Date: November 27, 2013 10:21PM

Hi Tannorp thanks for a great article I enjoy all your articles and have learned a lot!!


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Re The Great American Ponzi Scheme - Capital Intensive Businesses and Diminishing Returns
Posted by: TannorP@twitter (IP Logged)
Date: November 28, 2013 08:32AM

Thanks for the very kind words Jk815, Cheers, -Tannor


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Re The Great American Ponzi Scheme - Capital Intensive Businesses and Diminishing Returns
Posted by: batbeer2 (IP Logged)
Date: November 30, 2013 08:34AM

Thanks for an article worth reading.

>> Like most of us would know and agree, compounding capital or interest can work in the opposite direction, although asymmetrically (meaning a 50% loss must be made up by a 100% gain).

I think most investors would be glad to see half their stocks drop 50% today if the other half went up 100%.


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Re The Great American Ponzi Scheme - Capital Intensive Businesses and Diminishing Returns
Posted by: TannorP@twitter (IP Logged)
Date: December 1, 2013 04:04PM

No problem Batbeer and thanks for the kind comments.

I totally agree provided allocation concentration is equal in all holdings. I was attempting to address briefly the asymmetrical returns in the individual company's compounding capital. Great point though and another benefit of diversification as it would not be systemic risk pulling half down 50% while half advance 100%.

Cheers,


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