No.38: Management Trauma and Returns on Capital, Adaptation
This edition is inspired by a bit of consumer and energy watching, as well as a review of 1970’s economic conditions, coming out of the post-war boom. Also by my previous work in a commodity business. Enjoy!
Management Trauma and Returns on Capital
I was reminded of something interesting after the oil disaster of 2020, when prices went negative: Only a cynical, pain-loving person would keep their job as manager of one of these companies after years of disaster.
The same goes for banking after the Financial Crisis, as well as the auto restructuring of 2009-2010. These managers volunteered for a jobs that made them look ugly, be disliked by almost all constituencies for years at a time, and probably not get paid the most that they could.
My work in the timber business, at the high end of the cost curve, was a similarly scarring business. Most industry participants were only a bad decision and a banker's mood swing away from death. The near-death experiences taught me to trim cash to the bone, eschew any fancy trips, and conjure miraculous ways to improve the business - almost on a daily basis.
The team was very tight - while I was there we had 5 people max, and there were no one-hour internal meetings, or fancy office buildings. Even when business conditions improved, the near-death experiences were front of mind, and even after I left the business, the pressure to survive never left me. Such conditions ironically create very tight operators - if they survive.
The CPG industry was a different kettle of fish. Nobody ever talked about failure. No one ever spoke about having to adapt in the next ten days or be gone. It was assumed that a profit was going to be made every year. It was simply just a better, more durable business - where managers had grown up in an environment of absolute abundance.
Getting back to the oil business. I think it augurs well for the future ROIC that management have been through two traumas - 2016 after the shale collapse, and then again in 2020 when oil went negative. Now we see prices at $100/BOE and no sign that management is giving into the temptations of drilling more. They understand - not just on a spreadsheet - but emotionally too, that they cannot assume survival tomorrow.
This might change after 5 years of good operating conditions if future CEOs are drowning in cash and favoured by governments, employees, bankers, and ESG investors. But for now, management trauma looks set to produce higher ROIC.
As usual, we'll have to wait and see how this piece of writing ages.
Adaptation
Since inflation really kicked in, I see a shift in priorities of the households and consumers I talk to. Things that they held sacred only months ago are now being unceremoniously dumped - such as Netflix accounts.
Core needs - such as food and energy - are today's hot topics.
It therefore makes sense that the capital environment has also shifted. Since the underinvestment in energy has become apparent, we quickly realised that 10 minute meal delivery is a nice-to-have, rather than a must-have. Feeding your pet expensive treats becomes secondary when you can no longer afford groceries for your children.
People bought into tech stocks made a lot of money in 2020/2021 in, what was in retrospect, a tech hype cycle. The question is whether they can adapt and make money in the circumstances of the next decade.
A few fund managers I've talked to think I'm the idiot (and probably rightly so), and are expecting inflation to fade away, and the hype tech businesses to return to favour in a couple of years. Terms like "unit economics" and "cash flow break-even" still get airtime - though I'm happy to report that the "2030 EBITDA multiple" has been thrown out the window.
The fund managers I've spoken to might be right about the coming reversion to old conditions. But what if the world has actually changed - and adaptation is required?
After all, even die-hard energy investors in 2017/2018 might have been right about the underinvestment in oil, but they had to wait until 2022 just to break even. Capital cycles can last a long time. And most people don't have an attention span of 5 seconds, let alone capital from investors that lasts for 5 years.
But adaptation is hard. You have to stay in your lanes, and not venture into the latest Twitter fad just because you feel you should learn new trick. At the same time, if you try to use obsolete tools to analyse a new environment, you may be in denial like some of our tech bros.