Buffett is clearly right. The airline industry has been a disaster for investors. Richard Branson, founder of Virgin Atlantic Airways, wisecracked that the best way to become a millionaire was to start out as a billionaire and buy an airline.2
Certainly Buffett knows good investments. Over the thirty-year period from 1972 through 2002 his investment vehicle, Berkshire Hathaway, achieved an astounding 25.5 percent annual return, making thousands of his investors millionaires. There is only one firm that beats Buffett’s return over that thirty-year period: Southwest Airlines.
While air travel has undoubtedly improved the productivity of our economy—to be no more than a few hours from major population centers or vacation destinations frees time for both business and leisure travelers—the airlines are a prime example of an industry caught in a cycle of cost cutting, overcapacity, difficult unions, and high fixed costs that have ravaged their profits and led many airlines to bankruptcy. How did Southwest buck this trend? How could the single best investment of the last thirty years conduct business in an industry plagued by failure and bankruptcies?
Southwest’s triumph is marked by intense management focus on lowering costs and maintaining a competitive edge. In its 1995 annual report, the airline revealed its “six secrets of success.” Number one on its list was “Stick to what you’re good at.”
It is hard to put it much better than this. Don’t try to be what you’re not, and don’t try to do what you cannot. Economists call this activity “pursuing your comparative advantage” or “sticking to your core competency.” By focusing only on providing low-cost, reliable airline transportation to the masses, Southwest has become one of the few winners in an industry full of losers.
Southwest’s strategy is to be “the low-fare airline” every day in every market it serves. In order to accomplish this, Southwest knows it also has to be the low-cost airline as well. And the only way to attain the lowest costs is to obtain the most production out of its resources and its employees. Every aspect of Southwest’s operating strategy follows from this very basic tenet.
Southwest’s 1995 annual report lays it out: “[We] honor some simple no-nos: No assigned seats. No meals. No hassles. No problems.” This no-frills approach keeps costs down and allows the employees to focus on providing the service its customers expect.
Southwest offers only single-class service (no first class or business class) on a large number of flights to convenient airports. It does not try to expand into as many markets as possible or operate on a hub-and-spoke system like most other major carriers. Rather, it finds city-to-city pairs where demand is great enough to support a large number of flights.
Another productivity-enhancing operating strategy following the “keeping it simple” approach is its use of only one type of aircraft, the Boeing 737. Instead of having to store replacement parts and train its pilots and maintenance crew on a variety of aircraft, using only one airliner delivers significant cost savings.
Southwest’s approach paid extra dividends after the September 11, 2001, terrorist attacks. The airline industry faced a 20 percent drop in airline passengers following the attacks, the subsequent recession, and the start of the war in Iraq. The major carriers, burdened by billions of dollars of debt, overly generous labor contracts, and a structure that allowed little flexibility, found the downturn devastating. US Airways and then United Airlines were forced into bankruptcy, and others, such as American and Delta, have come perilously close.
But Southwest kept the profits coming, albeit at a much reduced level. In April 2003 the market value of Southwest stock exceeded the combined equity market value of all the other air carriers in the United States, despite carrying only 8 percent of the industry’s passengers.3
Certainly productivity was a key aspect of Southwest’s success. But more important was the focus on its comparative advantage: being a no-frills, low-cost air carrier. As I indicated in the first chapter, this has been the strategy of the world’s most successful firms. It is noteworthy that the world’s most successful investor, Warren Buffett, also attributes his achievement to knowing when he is “operating well within [his] circle of competence and when [he is] approaching the perimeter.”4
Retailing: Wal-Mart
Southwest is certainly not the only company that has turned high productivity and management focus into an investment success. In 1962 Sam Walton opened a variety store in the small town of Bentonville, Arkansas, population 3,000. By the end of the century Wal-Mart would become the largest company in the world measured by sales. Its 2003 sales of $259 billion were larger than the GDP of all but twenty-three countries on this planet.
Wal-Mart’s success did not come overnight. Sam Walton was never satisfied with his early stores and continually improved Wal-Mart’s operations and strategies. He incessantly studied his competition in search of new ideas. One retailing chain fascinated him more than any of the others, and he conceded in the early 1970s that it was a better retail outfit than Wal-Mart. “I spent a heck of a lot of my time wandering through their stores talking to the people and trying to figure out how they did things,” Walton admitted. Walton’s wife, Helen, recalled, “Sam never went by one of their stores that he didn’t stop and look at it. We would go through a good town, and he knew about some store there. I would sit in the car with the kids, who of course, would say, ‘Oh no, Daddy, not another store.’ ”5
What was that department store chain that so enthralled the founder of the world’s greatest retailing firm? Kmart. In fact, Kmart so fascinated Walton that he named his own stores Wal-Mart.
In one of the greatest ironies in business history, thirty years after Wal-Mart went public, Kmart, the inspiration for the greatest retailer in history, went bankrupt. A $1,000 investment in Wal-Mart would have been the third-best-performing investment over those three decades, falling just behind Southwest Airlines and Warren Buffett’s Berkshire Hathaway, while an investment in Kmart would have yielded nothing.
Wal-Mart, like Southwest, proves that a firm need not operate in an expanding sector or be at the forefront of technology to find success. But that is not to say that technology played no role in Wal-Mart’s success. Indeed, Wal-Mart pioneered the use of technology and communications equipment in managing and networking its stores to monitor sales. In 1969 Wal-Mart was one of the first retailers to use computers; in 1980 it began using bar codes at its counters for easier checkout, and in the late 1980s it was using wireless scanning guns to track inventory. And many who visited its high-technology distribution hubs exclaim that they have never seen a more impressive state-of-the-art system.
But, Wal-Mart’s productivity, which ranks as much as 50 percent above that of its competitors, has less to do with technology than the company’s strategic expansion strategy and management practices. A McKinsey & Co. report entitled, “The Wal-Mart Effect” concludes that:
The Wal-Mart story is a clear refutation of new-economy hype. At least half of Wal-Mart’s productivity edge stems from managerial innovations that improve the efficiency of stores and have nothing to do with Information Technology.6
Wal-Mart’s Strategy for Success
Wal-Mart’s competitive advantage was not that it discovered the power of discounting, which lured consumers away from department stores. That strategy was discovered in the early 1960s by Harry Cunningham, president of Kresge, the forerunner of Kmart. Cunningham aimed to take advantage of the shifting industry trends by closing 10 percent of Kresge’s existing variety store operations per year and rapidly expanding its discount operations. He opened the doors of the first Kmart discount store in Garden City, Michigan, in 1962.
In those early years Kmart expanded rapidly. By 1977 Kmart had nearly 1,800 stores, while Wal-Mart had only 195. Kmart’s success broke Sears, Roebuck’s stranglehold on retailing, and its stock was riding high.
Kmarts were located in large urban markets and used the same distribution network that supplied its variety store operations. But Wal-Mart was operati
ng from Bentonville, Arkansas—in the middle of nowhere. In these small towns, there were no big distributors to supply Walton’s stores. So Walton had big deliveries shipped to an old garage in Bentonville, repacked them into smaller packages, and then contacted another distributor to deliver these smaller packages to his stores. In Walton’s words, this procedure was “expensive and inefficient.”
But Sam Walton finally found the competitive advantage that he used to unseat Cunningham with devastating effectiveness. Instead of opening stores all across the country, as Kmart did, Wal-Mart expanded in clusters to minimize its transportation costs. It opened a few stores in an area that could be supplied by a distribution center nearby and then copied the same format in nearby areas where demand was sufficient to support as many stores as possible. Wal-Mart called this a “saturation strategy,” and it minimized transportation costs from the distribution centers to the stores. It worked beautifully. Kmart’s explosive growth, in contrast, planted the seeds for the company’s own destruction. Expanding with no regard for the cost of distributing its products, Kmart never fully committed to the discounting mentality.
Joe Hardin, a former executive vice president of logistics and personnel at Wal-Mart, once said, “A lot of companies don’t want to spend any money on distribution unless they have to. We spend because we continually demonstrate that it lowers our costs. This is a very important strategic point in understanding Wal-Mart.”7 Wal-Mart’s low cost structure is primarily a function of its distribution network and the deliberate manner in which Wal-Mart expanded.
Wal-Mart, like Southwest, initially succeeded by focusing on the small regional markets it serves. Similarly, both firms committed to low prices: Southwest’s motto is “The low-fare airline, every day in every market,” and Wal-Mart’s is “Always low prices.” Commitment to always being competitive in price is critical to their success.
Steel Industry: Nucor
After railroads and oil, the steel industry dominated the industrial landscape of the late nineteenth and early twentieth centuries. United States Steel Corporation was the single largest company ever to reach the public markets. Its market value in 1901, when it was issued, was $1.4 billion, making it the first public company in America to have a capitalization greater than $1 billion.
Bethlehem Steel has roots as far back as 1857. The Bethlehem Steel plant in Bethlehem, Pennsylvania, supplied the steel used in such landmarks as the Golden Gate and George Washington Bridges, Rockefeller Plaza, the Waldorf-Astoria, the Chicago Merchandise Mart, and the U.S. Supreme Court. During the Second World War, the company built 1,121 ships. U.S. Steel and Bethlehem were economic powerhouses that together supplied about half of this country’s steel.
But by the early 1970s U.S. steel manufacturers were already suffering from foreign competition. The number of steelworkers in the United States fell from 1 million during the Second World War to 140,000 in 2002. In that year Bethlehem Steel, one of the greatest companies in the United States, filed for bankruptcy, closing operations that had once employed 300,000 people. U.S. Steel limped on, but it was only a shadow of its former self.
Certainly the environment could not be worse for steel investors. Yet one company bucked the trend and delivered superior returns. Nucor, which has pioneered the use of “minimill” technology and the recycling of scrap steel, has provided investors with superior returns over the last thirty years. While other major steel companies were laying off workers and filing for bankruptcy, Nucor’s sales were growing at 17 percent per year en route to its becoming the second largest steel producer in the United States. And this paid off for Nucor’s investors. While the steel industry as a whole underperformed the market by close to 4 percent a year for the last thirty years, Nucor outperformed the market by over 5 percent a year over the same span.
Many attribute Nucor’s success to its use of “disruptive technologies” that overthrow old powerhouses such as the “Big Steel” companies. But Jim Collins, author of Good to Great, writes:
[W]hen we asked Ken Iverson, CEO of Nucor.… to name the top five factors in the shift from good to great, where on the list do you think he put technology? First? No. Second? No. Third? Nope. Fourth? Not even. Fifth? Sorry, but no. “The primary factors,” said Ken Iverson, “were the consistency of the company, and our ability to project its philosophies throughout the whole organization, enabled by our lack of layers and bureaucracy.”8
Another Nucor executive said, “Twenty percent of our success is the technology we embrace [but] eighty percent is in the culture of our company.”9
Collins concludes, “You could have given the exact same technology at the exact same time to any number of companies with the exact same resources as Nucor—and even still, they would have failed to deliver Nucor’s results. Like the Daytona 500, the primary variable in winning is not the car, but the driver and the team.”10
Although Nucor’s minimill technology eventually displaced the outdated technology of the integrated steel producers, such as U.S. Steel and Bethlehem Steel, its real comparative advantage lies in its relations with its own workers.
Ken Iverson described what he considers to be the problems of most corporations in his book, Plain Talk:
Inequality still runs rampant in most business corporations.… The people at the top of the corporate hierarchy grant themselves privilege after privilege, flaunt those privileges before the men and women who do the real work, then wonder why employees are unmoved by management’s invocations to cut costs and boost profitability.… When I think of the millions of dollars spent by the people at the top of the management hierarchy on efforts to motivate people who are continually put down by the hierarchy, I can only shake my head and wonder.11
Executives at Nucor had no lavish corporate dining room to host visitors; rather, they would take special guests to Phil’s Diner, a small sandwich shop across the street. At Nucor, executives received no more extra benefits than the factory workers. In fact, the exact opposite was true: executives had fewer benefits. Some of the extraordinary steps that Nucor takes to minimize class distinctions between executives and the others include:
• All workers were eligible to receive $2,000 per year for each child for up to four years of postsecondary education, while the executives received no such benefit.
• Nucor lists all of its employees—more than 9,800—in its annual report, sorted alphabetically with no distinctions for officer titles.
• There are no assigned parking spots and no company cars, boats, or planes.
• All employees of the company receive the same insurance coverage and amount of vacation time.
• Everybody wears the same green spark-proof jackets and hard hats on the floor (in most integrated mills, different colors designate authority).12
As Warren Buffett observed: “It is the classic example of an incentive program that works. If I were a blue-collar worker, I would like to work for Nucor.”13
Jim Strohmeyer, in his book Crisis in Bethlehem, depicts a corporate culture fraught with unequal treatment for executives and workers. Strohmeyer details Bethlehem’s executives using its corporate fleet for personal reasons, such as taking children to college or weekend vacations. Bethlehem renovated a country club with corporate funds, at which shower priority was determined by executive rank. Need more be said?14
Success amid Failure
Southwest Airlines, Wal-Mart, and Nucor. These three firms thrived despite being in industries that ravaged investors. What did they have in common and how did they buck the trend?
All these firms relentlessly pursued the goal of reducing costs and giving customers guaranteed products and services at the lowest possible price. These companies were pioneers in maximizing the productivity of their employees. These companies developed unique strategies that enabled them to become the low-cost producer in their respective industries.
Perhaps most important, these companies recognized that to achieve their goals, management must avoid corporate e
xcesses and develop a model working environment where employees feel part of a team that shares in both the customer respect for and financial success of their firms.
The success of these firms must make investors stop and think. The best-performing stocks are not in industries that are at the cutting edge of the technological revolution; rather, they are often in industries that are stagnant or in decline. These firms are headed by managements that find and pursue efficiencies and develop competitive niches that enable them to reach commanding positions no matter what industry they are in. Firms with these characteristics, which are often undervalued by the market, are the ones that investors should want to buy.
PART THREE
Sources of Shareholder Value
CHAPTER NINE
Show Me the Money:
DIVIDENDS, STOCK RETURNS, AND CORPORATE GOVERNANCE
“A cow for her milk, / A hen for her eggs,
And a stock, by heck, / For her dividends.
An orchard for fruit, / Bees for their honey,
And stocks, besides, / For their dividends.”
John Burr Williams, The Theory of Investment Value, 1938
On Tuesday, July 20, 2004, Microsoft announced an enormous one-time dividend payment of $3 per share, or a total of $32 billion for its almost 11 billion shares outstanding. In addition, the firm announced that it would double its quarterly dividend and buy back over $40 billion of stock during the next four years. Microsoft, which was founded in 1975, has given its investors an astounding 37.6 percent annual rate of return since it became public in 1986. For the first sixteen years of Microsoft’s public existence, 100 percent of that return came from the rising price of its shares—not a penny from dividends. But no longer. The size of Microsoft’s $32 billion special dividend was greater in value than all but about seventy companies trading in the United States, and it exceeded the entire market value of such firms as General Motors and Ford.
The Future for Investors Page 13
