Value Investing using Economic Value Added (EVA)

The Death Spiral in the "Accounting Based" Financial Management System

Insanity is doing the same thing in the same way and expecting a different outcome. 

Maybe businessmen in regulated or unionized industries, like steel and utilities, are insane.  Probably a better explanation is that they work in an insane system.  After-all, as Nietzsche said “Insanity in individuals is something rare, but in groups, parties, nations and epochs it is the rule”  He left out bureaucratic companies with antiquated decision making systems.

My good friend Marc Hodak at Hodak value Advisors sent me a note this morning - really early - about this Wall Street Journal story "Fixed Costs Chafe at Steel Mills".

It turns out that a few steel mills are raising prices even though demand is stalled at best at a very very low level.  Sounds like madness doesn't it?  Raise prices and demand should fall more, right?  But you see the guys that run those plants get paid on productivity usually measured by margins - and as the quote below shows their unit costs are rising fast so unit profitability is crashing.

We are raising prices because of the increased costs of operating our mills at the current lower levels. We are not seeing an increase in demand," said Dennis Oates, chief executive officer of Universal Stainless & Alloy Products Inc. He has boosted prices 5% to 6% twice since the beginning of May.

Think about this.  If they sell 10 steel bars for $20 each they collect $200.  If it takes $80 of direct materials to make the product and fixed costs like union labor and overhead is $100, then the total costs per unit sold is $80 + $100 = $180 divided by 10 units of steel bar, for a cost of $18 per unit.  $20 price minus $18 cost = $2 profit.

OK that's fine and dandy but what happens when volume falls in half by 50% to 5 units sold.  They only produce 5 units.  What happens to costs?  The CEO above says they go up - I say they did not change.

Let's look at the answer Mr. Oates' accounting financial management system gives him.  We know that it costs $8 of materials per unit for $40 ($8 x 5 units of steel bar) and we know the fixed costs are $100 or $20 per unit.  The unit cost in his system is now $40 + $100 units or $140/5 units = $28 cost per unit of steel bar-a 55% increase.  So according to his accounting system his costs are going up 55% as his demand declines so let's say he raises prices to $30 per unit to maintain his $2 profit margin.

What happens?  Well marginal buyers for steel go somewhere else and now he only sells 3 units.  Uh oh, now costs are really high. $8 per unit plus $100 in fixed costs divided by only 3 units now = $100/3 per unit or $33.33 per unit, for a total unit price of $8+$33.33 = $41.33 cost per unit.  That strategy really worked, he gets $30 per unit for $33.33 cost = -3.33 is what his accounting system tells him he loses.  What now?

Unlike mill increases announced in recent years, this is obviously not driven by increasing global demand, but rather by fixed costs being proportioned across significantly lower demand," the company said in a letter to customers.

This problem is known technically as the "unitization of fixed costs" or as Marc likes to call it - the "death spiral".  It happens when performance evaluation for a plant manager or employee is based on "unit costs" or "average costs", which includes fixed costs.  The problem is that fixed costs do not change as volume varies.

In this type of system two things will happen: 1. the manager will raise prices to compensate for his increased average cost per unit and then volume will fall thereby raising cost per unit further, or 2. The plant manager produces and produces regardless of demand so his volume and capacity utilization stay high, but his unit costs stay low because fixed costs divided more volume = lower costs.  Never mind that all those units just fill up a warehouse or a supplier where there is little or no end demand. Basically the managers bury the costs on the balance sheet in inventory which is costly but not to them because they are evaluated by margin per product or by minimizing unit costs.

If we charge them capital maybe they'll do the right economic thing and REDUCE FIXED COSTS IN DOLLARS.  Layoff workers, sell extra factory space, etc.

Marc sums it up like this in his note to me:

This strategy is based on (1) illusion and (2) delusion.  The illusion is that one’s “costs” are increasing when volumes drop.  But the only cost going up is the accounting fiction called “average cost.”  Variable costs, i.e., the economic floor for pricing, hardly budge.  Total costs, i.e., those that affect EP (economic profit), actually come down.  The delusion is that prices can be based on costs.(my emphasis) 

Read all that carefully and you will see why single payer health care, that relies on some Politburo of unelected experts to set reimbursement rates for doctors, nurses, hospitals, drug companies and medical device companies based on 'average cost", will massively misallocate resources.  Pricing off of costs is not market pricing and gives false signals and misaligned incentives to the good faith actors in any economic system.

Short the companies that don't get it; buy their competitors that get it, like Nucor (NUE). 

BERK

Disclosure: Long Nucor (NUE), no position in Universal Stainless (USAP)

Cost of Capital Rising Due to the "painful tug-of-war between our monetary policy and our fiscal policy"

Niall Ferguson, author of the Ascent of Money:A Financial History of the World, a book I just finished and  highly recommend to put today's economic recession and money panic in a sweeping historical context, wrote our title.  He said in  "History Lesson for Economists in Thrall to Keynes", Financial Times, May 29, 2009:

A month ago Mr Krugman and I sat on a panel convened in New York to discuss the financial crisis. I made the point that "the running of massive fiscal deficits in excess of 12 per cent of gross domestic product this year, and the issuance therefore of vast quantities of freshly-minted bonds" was likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. I predicted a "painful tug-of-war between our monetary policy and our fiscal policy, as the markets realise just what a vast quantity of bonds are going to have to be absorbed by the financial system this year.

At the end of last year, in the depths of the financial crisis, the yield on the 10 year US Treasuries was 2.1% - it is now over 3.6% - a huge move in a few months.  The problem for investors like us is that the yield on the 10 year is the base return we use to discount future cash flows to arrive at the present values of shares of companies.  The higher the interest rates go, the lower the fair value estimates of the shares of our Value-Aligned companies go. (In an efficient world that means stock prices in the stock market go sown too.) 

The 10 year treasury yield is one proxy for the cost of capital in the United States.  We are not saying that we used the low 2.1% rates that represented a flight to safety during the panic as our proxy for a cost capital, but we are saying that a steady move higher in the cost of capital of the United States is bad for investment in US assets - stocks, bonds, real estate and industrial investment (read US jobs).

...the stimulus package only accounts for a part of the massive deficit the US federal government is projected to run this year. Borrowing is forecast to be $1,840bn -- equivalent to around half of all federal outlays and 13 per cent of GDP. A deficit this size has not been seen in the US since the second world war. A further $10,000bn will need to be borrowed in the decade ahead, according to the Congressional Budget Office. Even if the White House's over-optimistic growth forecasts are correct, that will still take the gross federal debt above 100 per cent of GDP by 2017. And this ignores the vast off-balance-sheet liabilities of the Medicare and Social Security systems. (my emphasis)

It seems silly even to mention this but all that debt that the government has to issue to pay for the stimulus, the entitlements, the bailouts, etc.  must drive up interest rates - or else why would people buy it? 

Anyway, the Obama administration and Congress seem to care little about all this, or maybe they care but can't get their freight train to stop hurling down the mountain - that would mean their long held beliefs are inconveniently untrue.  Social justice may just be best arrived at when every segment of income is growing, when the pie is growing (see 1946 cartoon below).

Even with today's announcement that Congress will adhere to "Pay as they Go", which means in practice that taxes will be raised somewhere to pay for all the goodies that they will pay-off various feverish factions that are owed something for getting them all elected.  Probably more taxes on the ever shrinking "rich".

Ferguson acknowledges that the policy mistake has already been made by adopting the fiscal policy to fight a world war to fight a bad but not end of the world recession.

We need credible commitments to reduce our structural deficits AND credible that will raise growth - and revenues.  Raising tax rates on income and capital during a recession will further depress IRS collections thereby further increasing the deficit.

Growth is the answer and that means rolling back fiscal stimulus and attacking Medicare and Social Security in that order.  Unfortunately, this President thinks it means spending MORE on medical care to SAVE the system money - burn the village to save it.  The bond market and our customers in China don't lie - for the first time in my lifetime the solvency of the United States government is being questioned as though we are Argentina.

Buenos Dias.

BERK