Which is More Important: A Great Business Model or Good Management?

The answer is management, plain and simple.  When you invest in the stock of a company, you entrust management to be the steward of your capital and to make smart, value enhancing business decisions.  It doesn’t matter how great a product is or what competitive advantages a company may have, if management makes poor decisions they can drive the company into the ground.  Think of it like the Titanic.

Yesterday, I frustratingly sold our shares of Mead Johnson Nutrition (MJN) stock.  I’m just glad we got a bounce in the stock price the past few weeks.  I had high hopes for MJN as I wrote last summer:

…I believe Mead Johnson is the type of stock you can add to your portfolio today and forget about for the next 20 years.

We didn’t even make it a year.  It goes to show that you can never just forget about an investment and assume all will be well.  The reason I decided to pull the ripcord is poor decision making on the part of the CEO and the board.  Last October, the company announced that they were taking out $1.5 billion of new debt to fund an all-at-once stock buyback.  Unfortunately, this has become far too common over the last two years as Wall Street investment bankers pitch how “smart” it is to do this right now with interest rates as low as they are.  All Wall Street banks care about are the large fees for underwriting the deal, not the long-term impact this will have on a company.  I’ve noticed that just about every company that has done this has been penalized over the last year by the market driving their stock lower (as it should):

S&P 500 (black) vs. Buybacks Index (blue) – 2 years

The debt-fueled buyback boom has gotten a bit out of control, another unintended consequence of the Fed holding interest rates at 0% for so long, and it’s making me concerned:

I’ve commented before that I don’t like companies with a lot of debt when investing in the stock of the company.  Debt is leverage and leverage works in both directions so management better be very thoughtful in how they’re using the debt.  If they utilize it in a productive manner by purchasing an income producing asset (i.e. a factory, equipment, a rental property, a competitor, etc.) then you have a stream of income which you can use to eventually pay off the debt.  Also, the return the asset generates better be well above the rate of interest on the debt.  If so, you are creating value.  Conversely, if management wastes the money in a manner that does not increase the company’s cash flow generation abilities then they’re simply stuck with future interest and principal payments but no additional means of making the payments outside of existing cash flow.  Using debt to buyback stock is mortgaging the future to pull gains forward to today while hindering long-term value creation.  The only time I’m OK with doing this if the company’s stock is trading at an absurdly low valuation – and MJN’s was nowhere close to that.

I know I’ve talked about buybacks a lot before so I’m not trying to confuse anyone.  I love stock buybacks, IF… they’re done with free cash flow; not debt.  Those are two very different things.

Not that much has changed for Mead Johnson in the last year.  I knew about the weakness in Asian markets and the transition the company was making.  That’s what offered us the opportunity to buy the stock in the first place.  But when I bought the stock in the low 80’s, I was willing to pay a relatively high valuation for the long-term sustainability of the business model because they had such a clean balance sheet (basically no net debt).  With a fresh $1.5 billion of debt, I’m not willing to pay this valuation anymore.  By reducing the share count, we owned a larger percentage of the company, which is usually good.  But in this case, we owned a larger percentage of a leveraged company (a weaker balance sheet with a bunch of debt), which isn’t good.

What ultimately pushed me over the edge in making the decision to dump the stock was the annual letter to shareholders and quarterly results where they announced the average price paid during the buyback ($79/share).  The stock was trading in the 60’s for a few weeks!  They weren’t even opportunistic about the price they paid.  Also, the entire letter from the CEO to shareholders was pretty bad, but here are three paragraphs in particular:

Economic growth slowed in almost every country across what have historically been our two fastest growing regions of Latin America and Asia.  Consumer and retailer confidence suffered as a consequence, resulting in weaker demand across markets in those regions.

In a number of key markets, we experienced deflationary pressure on pricing, in part due to weakening commodity prices.  This situation was brought on by intense competition for volume in markets with static demand.  And, in some cases, government regulators exacerbated the situation by deploying anti-inflationary policies in markets with deflationary pressure.  The net outcome of all this was growth rates lagging historical norms across Latin America and Asia.

In the second half of the year, we began to experience the adverse effect on earnings of a strengthening US dollar.  We derive nearly three quarters of both our sales and earnings from outside the United States; hence, the impact was substantial. 

Other than mentioning some cost cutting initiatives, there were no comments on new initiatives, no stated goals, no numbers; just complaining about a tough macro environment (as if they’re the only company that does business overseas) and some vague comments about their long tem commitment to being a good company.  This tells me that the CEO and board succumbed to Wall Street pressure to do “something” that boosts short-term results despite it putting the company in a worse position which will inevitably hinder long-term value.  This is not a management team that I feel I can trust to be a steward of our money.

-Nick