Never, Never

Reprinted from Whitebox’s Monthly Returns and Review, March 2014

Imagine a few months from now Mark Zuckerberg calls a press conference to announce his goals for Facebook for the next few years. As the crowd waits with baited breath, he announces three:

1. To have Facebook recognized as the world’s coolest company.
2. To triple the number of Facebook employees, because there are so many cool things to do and because we all have to work together to fight unemployment.
3. To make Facebook employees on average the highest paid in the world, because income inequality is incompatible with FB’s values.
4. He makes no mention whatsoever of Facebook’s profit goals or other financial obligations to shareholders.

On a scale of one (yawn) to ten (catatonic with shock), how surprised are you?

Probably not “one,” but surely not “ten” either. I’m guessing for most people who have followed FB the shock meter would not get above four. After all, Zuckerberg has never given much evidence of caring about the financial return to the FB shareholders who have made him a billionaire.

The question before the court is whether Zuckerberg/Facebook are sui generis or just the most grotesquely obvious poster children for an emerging phenomenon. Our guess is the latter. To us, Facebook is simply best of breed of a new class of firms we like to call the “Never, Nevers.”

What is a “Never, Never?”
A Never, Never is a public firm that will never, ever make profitability its first priority and will never, ever willingly deliver a penny of cash back to shareholders. It will never pay a dividend; it may never buy back stock. Shareholders may make a buck reselling to greater fools. That will be no thanks to management, who will not even give the appearance of trying to manage to shareholder value.

We christen the Never, Nevers in ironic homage to the great Ben Graham’s “Net, Nets.” The Net, Nets were firms whose current assets, net of anything dubious such as overvalued inventory or receivables, and then net again of all company liabilities, long term as well as short, exceeded the market value of their stock. In effect a Net, Net stock was a pile of cash selling for—less cash. If cheap enough, it could be like “buying a dollar for 50 cents.”

The buyer of a Net, Net thus made a pure economic calculation with no admixture of wishfulness, no embellishing narrative, no dreams of a better future to justify a more imaginative price.

Heretofore the opposite of the Net, Nets have been the story stocks, firms that in their purest forms are all future, no past, and little present. Precisely because the story stock has so far done so little, it appears as if it might yet do almost anything at all.

The great day of the story stock was the tech bubble when “.com” was a name to conjure with. Analysts desperately designed alternative valuation metrics (“eyeballs”) with which to distract investors from such quotidian considerations as P/E, or P/S, or for that matter just S. Though a perennial source of grief to many an investor, story stocks had at least this virtue: As written they all had happy endings for shareholders, however implausible. It might seem a stretch that eyeballs could be superior to current sales as a measure of future earnings, but at least the advocates of the company understood that future earnings were the goal. It might be doubtful that shopping for dog food over the Internet would be the next big thing. It might seem long odds that some new fiber optic device launched against a dozen similar competitors would rule the new world. Yet however unlikely these happy endings might be, all concerned did actually believe that if they, improbably, got to the end of the rainbow the reward would be denominated in nice solid pots of gold, and the shareholders would get theirs. It may have been a fairy tale, but fairy tales have values and creating wealth for shareholders was clearly in the top rank.

The Greats of Never, Never Land do not make even this concession, or if they do so in words, all their actions belie it.

How Did We Get Here?
I admit that to those of my generation anyway the very existence of the Never, Nevers seems unlikely. We came of age in—and partly built—a culture in which the obligation of management to create shareholder value approached the status of a moral absolute. This standard, however, which seems so natural and obvious to those of my generation, was not nearly so dominant even when we were children.

This should not be surprising. Neither the formal structure nor the history of the large public corporation suggests that it exists primarily to do the will of shareholders. Though shareholders are called owners, they have nothing like the rights or privileges of real owners: no inside knowledge of the firm and no practical say in most decisions. It takes astonishing effort for a popular shareholder movement to wrest control from current management. Such movements, even when they succeed, are almost never sustained. In the face of this de minimis sort of ownership, it requires an assertive force in the culture to sustain the idea that corporations are anything like “pass-throughs”–insubstantial vehicles of financial convenience assembled to manage the cycle of invest, produce, return-earnings-to-investors. The contemporary vision of the large public corporation as a primarily financial phenomenon that might at any time be dis-intermediated and reorganized for greater efficiency in delivering earnings to shareholders is neither natural nor obvious.

In our youth, certainly, public corporations looked more like enduring social institutions charged with multiple mediating functions not best handled by either the solitary individual or the power of the state. In those days no one used the word “stakeholder,” because it was unnecessary. The word shareholder did not then have such mythic power that we needed a separate word to remind us that shareholders were not the only persons who had a claim on the corporation’s loyalty.

The boomer era was the era of meritocratic individualism, the era in which the fierce calculation of price overwhelmed reciprocity and relationship, the era in which markets weighed institutions in the balance and solidarity was renamed “rent seeking.” And it began with massive efforts to get corporations to give corporate owners their due: the LBO movement, which bought out public shareholders altogether often at attractive premia; and the stock options movement, which tied executive compensation to the creation of shareholder value. If corporations inevitably served the interests of shareholders, there needed to have been no great struggle in the ´70s and ´80s to get them to do so.

Most of the behemoth, integral, almost “self-conscious” firms of the post-war era had been, within living memory, established by great founders, men who exercised essentially total personal control of these firms even after they went public. Query these men as to the “mission” of their firms, and not one would have mentioned the public shareholder in the first 10 minutes. In time these men passed the governance of their firms not to the public shareholder but to professional managers. These managers in turn derived their legitimacy in part from powerful self-conscious corporate cultures that effectively steered decision making. The notion of “the organization man” would not have been possible without self-conscious, integral organizations replete with defining principles and prejudices to which the organization man could be loyal.

Howe and Strauss, the authors of the Fourth Turning, argue that the characters of succeeding generations are formed not only by what they receive in inheritance but what they react against in impatience. On these grounds, the notion of the corporation as shareholder servant seems like a doubly endangered species.

As I have already noted, the idea that corporations exist primarily to serve their shareholders is insufficiently supported by law or experience to be embraced except under the pressure of a powerful cultural force—such as boomer individualism. In many of the old industrial firms however, the shift in numbers during the past several decades was also on the side of the shareholders. The ranks and power of strong stakeholders, such as unionized employees, shrank even as shareholders became more numerous and demanding.

Firms like Facebook are in quite a different situation. Their stakeholders vastly outnumber their shareholders and wield far more power. A remarkably large percentage of human beings are Facebook shareholders, but their numbers pale in comparison with the number of Facebook users, now exceeding a billion. Multiply the numbers by the passion of their involvement, and it would be shocking if Zuckerberg were not far more motivated by the sentiments of his users than his shareholders, which, in his case, is almost to say by the sentiments of the public at large.

Undermining the shareholder as well is the one most seeringly obvious result of boomer individualism: the wealth of the 1% of the 1%, the one in 10,000 Americans with average incomes measured in tens of millions. Bill Gates, a man of my generation, made and continues to make fantastic sums from Microsoft—alongside his fellow shareholders—which he then proceeds to give away, consulting almost solely his own views. One may complain that Zuckerberg is failing, nay refusing, to make any such sums for his shareholders, but he still owns so much of FB that no one suffers so much as he from his indifference to earnings. If Zuckerberg is already wealthy beyond the dreams of avarice, the least that may be said is that he does not dream of any more.

The apotheosis of the shareholder in the boomer era was corollary to the liberation of the talented individual, especially in the guise of entrepreneur. Society conceded vast power and wealth to the exceptional entrepreneur on the understanding that the great innovator ultimately enriches others more than himself. By analogy the individual investor, though often a fool, was seen as an entrepreneur in miniature, allocating capital to its highest and best use, or at least willing to risk that he was doing so. Also presumed to be a net contributor to the common good, the investor seemed worthy of some of the deference shown the true entrepreneur. Thus the culture conflated capitalist with capitalizers, the innovator with those who leapt (blindly enough) onto his bandwagon.

Today, in the wake of multiple market disasters and trillions in misallocation and waste, does it seem obvious anymore that the thirty thousandth richest shareholder in America is worthy of the honors and perhaps accidental riches heaped upon him? Not having met him I cannot deny it; he may be a man of sagacity and prudence; his judgment in the use of capital may well have been of greater benefit to the commonwealth than to his own purse. But does that possibility seem likely to survive as an imperative assumption in the coming cycle of American life?

We don’t expect many American companies to become Never, Nevers for the same reason we don’t expect Facebook, under current management, to be a darling of shareholders a decade from now. If the value of a stock is the appropriately discounted value of all future dividends, we believe the correct valuation of a Never, Never approaches zero, arguing for their continued minority status.

Our point rather is that we are entering an era in which the culture will likely be less supportive of shareholder claims on corporate wealth and that shareholders themselves will therefore likely grow less demanding. In such an environment Never, Nevers become plausible in a way they would not have been 20 years ago.

A Never, Never need not be run by a Zuckerberg, who sometimes seems to consciously scorn his shareholders. More likely most Never, Nevers will simply slip gradually into bad behavior enabled by some combination of shareholder passivity and manager egomania.

Profile of a Never, Never
What would a Never, Never look like statistically? Would it be possible to screen for them? We’ve been thinking about that and so far we’ve come up with four criteria:

1. Just to clear the decks, we exclude any firm of less than a billion in market cap. Infant firms may have all sorts of good reasons for hanging on to their cash. Also a Never, Never ought to be a big enough deal to develop delusions of grandeur.
2. Annual revenue growth of at least 10%. Again a firm that is not growing has all sorts of reasons not to be generous with shareholders; we want to look at firms that should be but aren’t. Unlike story stocks, Never, Nevers are real, even impressive enterprises; simply indifferent to letting shareholders share. Also on the FB pattern one wants Never, Nevers to be emerging cultural phenomena, which implies growth.
3. Operating expenses growing even faster than revenues. A mid-sized company growing revenues by 10% has reached the stage where it should be thinking about getting value to shareholders. Allowing expense growth to continue to outpace revenue growth at a late stage suggests otherwise.
4. Net cash generated by financial activities is positive. In short, this company is absorbing capital, not returning it to shareholders, e.g. it is not buying back stock or paying off debt. An indifference to growth in the claims on the company’s earnings suggests an indifference to getting value to shareholders.

Running that screen we came up with more than 100 names, which was clearly too many. We then performed additional fundamental analysis including looking at management statements and behavior and we came up with 18. We are currently short all of them; several we were short already before the exercise. Without further ado then:

The Whitebox Never, Never Index*

 

*Composite scores (the screen) were determined by using proprietary Whitebox calculations to determine relative rankings in Cap Structure and Liquidity, Growth, Profitability, and Technical Factors and Valuations of the 500 largest companies by market capitalization as of 3/31/14.

 

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