This article is the 4th in a 6-part series by GreenWood Investors, examining how the drivers of value creation are the same as sustainability drivers. We outline these drivers in these 6 posts and show how recent ESG efforts to define business sustainability fall very short.
Q4 2020 hedge fund letters, conferences and more
The Monopolist’s Curse: United Fruit Company
The very odd Covid-modified holiday period had me unusually nostalgic for past Christmases, where traditions were supplemented by a longer reading list, with a particular focus on the period following the last major global pandemic. In the more recent past, my aunt and I had a tradition of playing Monopoly. My aunt is a guidance counselor, and an incredibly loving human being who has helped tens of thousands of children over the past four decades cope with becoming young adults. Not an enviable task.
But when it came to playing Monopoly, maintaining this gracious posture made for an incredibly rewarding counter-party. At an early age, I figured out how to compound my board game profits and even leverage up to continue to build as quickly as possible. I was ruthless when it came to board domination, often leaving a tense dynamic in the hours ensuing the game.
But my aunt learned quickly, and met this young ruthless monopolist with an equally hardened business demeanor. She learned survival in a world where her economic counter-parties were going to take what they could and leave little behind. She adapted, but for a few hours, gone was the loving and joy filled aunt that I loved.
As I later learned, it turns out fighting monopolies may be a dormant gene in my family. My grandmother’s Vaccaro family built the Standard Fruit Company in New Orleans- a challenger to the dominant banana monopoly of the early 1900s, United Fruit Company based in Boston (now operating under the Chiquita brand).
In her final years, my grandmother’s near-term memory lapsed, but her long-term memory had her recalling vivid scenes from her childhood in the 1920s. Rolls-Royces with chauffeurs, tales from the ice machines at the Port of New Orleans and getting to play a sort of Eloise at what is now the Roosevelt Hotel (which used to be the Vaccaro Hotel) provided the backdrop for very rich memories. Not glamorous was the hard truth that this family got sucked into the stock bubble of the late 1920s and lost the entire business due to stock trading.
That’s another useful lesson, and particularly timely in this moment, but requires a separate conversation. United Fruit scooped it up for next to nothing. That company is now the Dole Fruit Company. It was a particularly hard Depression for her and her family.
Becoming a Whale
An incredibly well-told tale, The Fish That Ate the Whale, talks of a similar immigrant entrepreneur that not only took on the monopolist United Fruit Company, but ended up taking over its management in a proxy contest. Sam Zemurray of Cuyamel fruit company was the epitome of an owner operator, he was on the ground with his guys in the fields. He personally scouted for land overlooked by others. In the evenings during harvest, he would drink with the plantation workers. My favorite parts of this book captured how Sam was able to gain critical advantages versus the monopolist United Fruit by spending most of his time testing different varieties, plots of land, shipping methods and fighting off bureaucratic impulses of his growing fruit company.
“He was respected because he understood the trade. By the time he was forty, he had served in every position, from fruit jobber to boss. He worked on the docks, on the ships and railroads, in the fields and warehouses. He had ridden the mules, he had managed the fruit and money, the mercenaries and government men, he understood the meaning of every change the weather, the significance of every date on the calendar.
There was not a job he could not do, nor a task he could not accomplish. He considered it a secret of his success. He was up every morning at dawn, having breakfast, standing on his head, walking in the fields. As far as possible, he refrained from giving interviews, addressing shareholders or attending functions, all of which took him away from his work. He was one of those men who toiled all day and every day until they had to be rolled away in a chair.”
All of the most talented managers in the banana trade left UF and “flocked” to Zemurray’s Cuyamel. Its stock price kept rising, and he kept redeploying all profits back into new business development while UF’s kept languishing. This stood in very stark contrast to the “mothership” management style of United Fruit and the dividend maximization for shareholders.
Watching Cuyamel rapidly erode its strangle on the industry, UF took out his Cuyamel business for a very fancy price, and made this swashbuckling immigrant an offer he couldn’t refuse. But very soon after the 1929 buyout, Zemurray’s entire net worth, then converted into UF shares, collapsed.
It turned out even hiding in a monopoly wouldn’t help mitigate the disastrous consequences of 1929 stock market bubble. The management floundered and results deteriorated very considerably despite having taken out its two challenging banana traders Cuyamel and Standard. Irritated to say the least, Sam mounted a proxy contest, being the largest shareholder of the company, and forced out management and then replaced the board.
“It was a marriage of opposites… Zemurray’s personal style, as well as his operating practices, were completely contrary to the traditions of United Fruit. Zemurray had lived in the tropics and had personally pioneered many of the practices in agriculture and engineering which became the standards for the industry. By contrast, the management of the United Fruit company had been content, for the most part, to sit in Boston and count the money, and watch bananas grow with the same detachment with which an actuary watches the growth and death of populations.”
But after Sam overtook the management of United Fruit, he resorted to more aggressive management tactics. He spurred coups against governments that were unfavorable to the land holdings of UF.
As author Rich Cohen wrote in the preface talking about UF under Zemurray’s leadership, “United Fruit in its day was as ubiquitous as Google and as feared as Halliburton. More than business, it was the spirit of the nation abroad, akin to the Dutch East India company. Its policies backed by the threat of US Gunboats. As the president of UF, Zemurray became the most important man in Central America. He could change the course of history with a phone call. A symbol of the best and worst of the United States. Proof that America is the land of opportunity but also a classic example of the ugly American, the corporate pirate who treats foreign nations as the backdrop for his adventures.”
Becoming Over Being
We often hear investors talk about their desire to invest in unregulated monopolies. This sounds understandable at first, particularly from the perspective of someone who had learned the trick to the game Monopoly at an early age. But it’s ill advised. Monopolies are most typically post-growth businesses. Zemurray built his fortune as he challenged the monopoly, not after his business was gobbled up by the whale.
As a monopoly, by definition there are no more growth opportunities outside of overall market growth or abusing your power. Fortunes are built as companies become so essential that they naturally become monopolies. While monopolies can protect a fortune, they often guarantee its long-term obsolescence and irrelevance.
After its market share reached near 100%, growth was very hard to come by. This led Zemurray and UF into very ugly territory. The company fomented wars and was largely responsible for the “banana republic” instability of governments in Central America. By 1940, the company owned half of all private land in Honduras even though it cultivated less than 10%. “It became a symbol of concentrated wealth, more powerful than the government itself.”
This abuse of that power that monopolies allow, almost always leads to a stagnant “bean counting” culture that Zemurray found in Boston. Parker Brothers and the creators of Monopoly were trying to expose the inadvertent ruthless behaviors that inherently emerge as business enterprises seek commercial scale without moderation. While we can criticize it when we find it in others, the most honest of us will admit we all have these tendencies. Even a middle school guidance counselor, when push came to shove. Knowing how far to push something is not something humans are very good at, as we see in today’s marketplace so starkly. Relying on bottom-brain, ego tactics, which commercialization requires, has felled an incredible number of value creators over the ages.
And there is overwhelming evidence that today’s newest vintage of monopolizing tech firms are increasingly resorting to predatory tactics that have caused its forbearer monopolies to stagnate and decay. The antitrust regulators around the world and attorneys general everywhere have been unleashing a wave of suits against Google in particular, a firm which hides behind its very pro-consumer stance to eviscerate competing AdTech firms.
Google has added a tremendous amount of wealth to its share-owners, and more importantly, to the process of information discovery, but the easy low-hanging bananas have been thoroughly picked over by its traffic monetization strategy. Growth from this point on requires increasingly aggressive behavior, risking a destruction of the ecosystem they have so carefully cultivated over the past two decades.
The last major leg of growth for Google will come as it eliminates the cookie, takes even further market share and closes in on a monopoly position in the digital ad industry. While Facebook is a credible second place, its agreement with Google to not run competitive tools while receiving prioritized inventory, ensures these two are functioning in complete harmony from a competitive standpoint.
Hitting Refresh
While many can argue whether or not Google is there, we believe it is still one or two years away, let’s look at the first modern tech monopoly to emerge: Microsoft.
Until the birth of the mobile computing and mobile operating systems, few would deny Microsoft had a monopoly position on personal computer operating software, and even basic business tools. There was essentially no competition, particularly into the latter part of the 1990s, which is when noticeable cracks in its competitiveness first started emerging. Windows refreshes continued to deteriorate and its tools and platform became increasingly crash-prone and difficult to use.
And until mobile ecosystems overtook desktop as the consumers’ primary computing tool, shareholders could have been forgiven for not noticing the very apparent stagnation in the company’s competitiveness. Revenue continued to grow at double-digit rates as its monopoly position allowed it to lift prices and force desktop upgrades, which to the user felt more like downgrades.
But in the wake of Apple introducing the iPhone, the subsequent decade saw Microsoft struggling to even generate mid-single-revenue growth in a rapidly growing computing industry. As late as 2013, the stock price was sitting around the same levels as 1998, the year after the department of Justice sued the company for monopolist practices, after Apple had very clearly lost its PC war against the company.
It wasn’t until Satya Nadella took over management of Microsoft in early 2014 that the company was able to return to double-digit growth and the market rewarded it with a higher stock valuation. He completely pivoted away from the monopolistic position and “hit refresh” as his book is titled.
He completely divorced the Azure cloud platform from Windows and opened Office products up for use on any platform. It was a radical pivot away from “mothership management” to an embrace of an ecosystem approach. Customers responded accordingly, with its software and platforms more readily used on their technology of choice, and Satya reignited top line growth, sending shares quintupling as he opened up the closed ecosystem and embraced competition.
What Matters Can’t All Be Measured
“Cecil Graham: What is a cynic?
Lord Darlington: A man who knows the price of everything, and the value of nothing.
Cecil Graham: And a sentimentalist, my dear Darlington, is a man who sees an absurd value in everything and doesn’t know the market price of any single thing.”
- Oscar Wilde, Lady Windermere’s Fan
While economics is a useful social science, it is numerically-oriented, which makes it a particularly poor science for understanding and measuring welfare. As the seemingly infinite value of a loving mother’s care of her children will attest, we do a pretty poor job in the economic world of measuring human welfare. The value of my aunt’s career as a guidance counselor for 35 years cannot be measured solely by the dollars she was paid over that time period. The value she has created to society surely cannot be measured in dollars, which is why in the 1930s, the marginal utility theorists largely gave up and accepted consumption as the best proxy for measuring this welfare or utility.
As Mariana Mazzucato points out in her thought-provoking work The Value of Everything, “Underlying this common sense approach to household work is the utility theory of value: what is valuable is what is exchanged on the market. This implicit production boundary is determined by whether money changes hands for the service. Therefore, there is extreme difficulty in giving a value to work done by women or men who do not receive a wage in exchange for it.” She goes on to explain the inherent limitations in how we measure progress.
“If value is defined by price, set by the supposed forces of supply and demand, then as long as an activity fetches a price, it is seen as creating value. So if you earn a lot, you must be a value creator. I will argue that the way the word value is used in modern economics has made it easier for value extracting activities to masquerade as value creating activities, and in the process, rents on earned income get confused with profits- earned income. Inequality rises and investment in the real economy falls.
What’s more, if we cannot differentiate value creation from value extraction, it becomes nearly impossible to reward the former over the latter. If the goal is to produce growth that is more innovation-led, smart growth, more inclusive and more sustainable, we need a better understanding of value.”
In her work Mariana exposes the perversion of how we measure value creation by showing Wall Street activities, which are largely a tax on wealth transfers, are considered value-additive in the current GDP calculations. If a real estate agent charges less for their services for the same activity, the productivity of the economy improves. But if Wall Street charges less for transactions and lending, it is counted as a deterioration in economic activity. Accordingly, we are rewarding value extraction, perhaps at the expense of value creation. It sounds very similar to the fact that companies can report banner earnings per share figures while also deteriorating the fundamental resilience of their businesses.
Our score card for value creation is inherently limited by the math we use. That is what the ESG (Environmental, Social and Governance) movement is trying to solve for. There are considerable differences between sustainable value creation and the reported earnings of a company.
Mariana’s work is at times one-sided, as she tellingly chose to remove the last line of Oscar Wilde’s famous passage from Lady Windermere’s Fan which exposes the flaws of ignoring mathematical reason. But her thinking is fresh and creative, and in a world dominated by GDP measurements and stock prices serving as proxies for value created, she has a very important point. There are a tremendous number of highly important effects of our actions that simply cannot be measured in economic units of value.
While customer happiness and employee engagement partially show up in the growth trajectory of a company’s income statement, the externalities, or side of effects or consequences of the company’s activities are surely not showing up in the profit & loss accounts. It is the requisite role of governments to set regulatory policies that will reflect these externalities into economic governance. These regulatory conditions are most effective when they use the same market forces that help determine prices and distribution of goods and services.
Carbon cap and trade was quickly written off as a failure after its introduction in the European union, as carbon prices fell dramatically after markets were established in 2005. But after the economy grew into the allocated credits, carbon markets have staged a material come-back and represent a real financial burden to the carbon polluters on the continent. Effectively, the price of the emissions are now factored into the underlying sales price of the product or service.
The Limits of Regulation
But as Zemurray showed in United Fruit, when companies transcend borders, the government will have less influence over the complete range of its activities, a limitation that is particularly exposed today. When the Justice Department sued United Fruit for violations of the Sherman Antitrust Act, the Supreme Court ruled that it didn’t have the proper authority to judge the merits of the case, as nearly all of its activities happened outside of US borders. Thus, multinationals are inherently more difficult to regulate and thus have an even greater responsibility to minimize its own externalities. As the incentives of the Parker Brothers Monopoly game remind us, they rarely do so.
Regulation also has a deeply anti-competitive side effects. Regulators love to create multiple-thousands of pages of rules for companies to adhere to. This eliminates the ability for any small challenger firm to compete on the same playing field as the gorillas with their legions of lawyers. Big banks actually loved Dodd-Frank while the “walled gardens” of Facebook and Google actually loved the GDPR regulations. It strengthened their monopolist control on ad targeting.
Further, what regulation enthusiasts around the world fail to realize regularly is that for underlying patterns of human behavior to change, economic forces must play a pivotal role in their adoption. Electric vehicles (EVs) largely failed to gain any traction until the tax credits made it economically viable.
But EVs didn’t gain popular attention until Tesla made them sexy. I remember at the time we owned Ferrari as a standalone company, in late 2015, it was already popularly proclaimed that Teslas turn more heads in town than a Ferrari. Musk made the EV sexy, and humans don’t behave according to their rational minds. Particularly as a consumer, they make choices with their emotional minds. The mind of the marketplace. The bottom part of the brain.
So while the intention of the ESG investor movement is particularly noble and well-intentioned, it doesn’t have legs for delivering on its promises unless it becomes an integral part of the business strategy and market approach. Sustainability is not a box-checking exercise, where companies can implement “best practices” set by lawyers and consultants.
Nikola Motors has an incredible board of directors, multiple long-term industrial partners, and came to market at a particularly lucky moment when EV stocks were being traded like the Pets.com’s of 1999. It sought to address an under-served part of the EV market, but as Hindenburg Research showed, it was largely a castle built on sand. Nikola checked nearly all the ESG buckets, but it was the polar opposite of a sustainable company.
The herd movement into these stocks over the past few years have driven valuations roughly three standard deviations above their post-GFC trading range. There will be many more Nikolas taking advantage of these exceptionally frothy conditions, given this undiscerning stampede of capital. That possibly risks the sustainability of this wave of sustainable investing as merely a fad.
Exhibit 1: Fund Flows & Equity Valuations for ESG Companies
Source: JP Morgan
Even Mazzucato admitted, after arguing for the virtues of separating shareholders from the governance of the company, in an attempt to check the greed impulse, this view faced a stunning defeat in the wake of the Volkswagen diesel-gate scandal. “The car-maker boasted several attributes which agency theorists consider helpful for far-sighted investment and honest practice: widening the shareholder base and extending its interests beyond short-term profits. German workers, who would have little to gain from tricking US consumers, had a powerful say in the company’s affairs. A family holding company, a German state, and a Middle Eastern sovereign fund control 90% of the shareholder votes. All are very long term investors.”
The regulatory response to Dieselgate outside of the United States was hardly inspiring. German regulators led the response in Europe for the company, where it sold 20x more faulty vehicles, which basically slapped the company’s wrist and allowed for a software change, which a UK class action lawsuit alleges did not even solve the emissions problem for 70% of all journeys in England.
Volkswagen imposed a significant negative externality onto the populations of the affected areas: as NOx emissions have been linked to very harmful health side effects. But if we can’t count on regulators to impose responsibilities on companies that break the spirit of the law, if we can’t count on ESG standards, what can we count on?
The Responsibility of Freedom
“Strictly speaking, shareholder value is the dumbest idea in the world.” - Jack Welch
After spending many of the past years searching for the silver bullet to value creation, I’ve come to admit, there is no magic formula. As Sir Martin Sorrell said in a conversation with our investors in December 2020, “you know it when you see it.” There are patterns of behavior that rhyme between value creators and long-term focused managers. The tenets of value creation are in harmony with those of sustainability – for there is no long-term value creation if that process is not also sustainable.
But while there’s no silver bullet, ensuring that management is not divorced of the long-term ownership of the company goes a long way to fostering the most sustainable businesses. Owner managed firms shun a lot of the casino capitalism traits, and in particularly the quarterly guidance charade. They conduct less mergers & acquisitions and they invest more in their people and core businesses. But as Sam Zemurray showed at United Fruit, this also isn’t a silver bullet. His scrappy bottom-up management style buckled under the weight of having to manage the octopus that acquired his firm. He ended up presiding over more than a few decisions that would have been given a clear F-rating from a sustainability perspective.
Even still, as Credit Suisse showed in its most recent research on Family-controlled companies, the largest 1,000 global family controlled businesses have consistently scored above average on environmental and social scores. Unfortunately the proxy advisory firms and popular wisdom still claim that having controlling shareholders or families is considered a “negative” versus the agency model that Mazzucato and many of her colleagues promote. Thus, these family controlled businesses score low on “governance” criteria, while still trouncing their peers on the overall factors.
Exhibit 2: Credit Suisse’s Family 1000 ESG Performance
Source: Credit Suisse
In his highly enjoyable tale about co-founding Netflix, Marc Randolph talked about this cultural dichotomy that he tries to balance as a manager. While Netflix’s culture is now famous and has been made into a widely circulated powerpoint presentation, there were no stated principles in the beginning. There was no mission statement. The culture developed organically.
The team embodied the principles as opposed to codifying the principles on paper. Randolph talked about how his former employer Borland had all the perks in the world, with a very honorable mission statement, but they didn’t feel at all connected to it. It was a nanny state, or what I’ve called “mothership management” style. Writing in That Will Never Work, he explained.
“I knew that I, and everyone else on the initial team, would thrive if given a lot of work to do and a lot of space to do it. That was really all our culture amounted to. Handpick a dozen brilliant creative people, given them a set of delicious problems to solve, and then give them space to solve them. Netflix would eventually codify this as ‘freedom and responsibility.’ But that was years later. At the time, it was just how we did things. We didn’t have set hours for work. You could come in when you wanted, leave when you wanted. You were being judged by what you could accomplish.”
While Randolph was talking about his management style as a serial startup founder, he could have as easily been talking about an ideal approach to the regulation of companies. Those that embody a natural responsibility in their approach to their customers, employees, communities and the environment around them deserve the freedom to operate more independently. But they must still generate respectable returns for investors. That is actually the first requisite, as Adam Smith espoused in his founding text for the entire field of economics.
While I’m personally intrigued by Danone’s efforts to become the world’s largest B-corp, which seeks to balance the needs of all stakeholders as opposed to just the stockholders, the languid development of the business over the past few years and the corresponding even worse returns for its owners bode poorly for many other companies following in their footsteps. This is not a great development for the ESG investment movement as, like Volkswagen, it was such a high profile case study. Perhaps Danone needed to focus on the financials a bit more than creating its kumbaya supply chain.
On the other hand, those that focus on shareholder value at the expense of all of these other stakeholders, as most monopolies do, and as GE did for decades under Jack Welch, deserve more scrutiny and probably more regulatory restrictions. When looking back on his career, Welch caveated that shareholder value maximization, on its own, doesn’t make sense. It needs to be taken into context of everything else the firm was doing. This was a shocking confession from the manager who most popularized the concept.
I think we can take a lesson from Oscar Wilde’s complete quote from above, not just the first sentence about the man who knows the price of everything, but the value of nothing. Not all things that matter can be measured, that is very clear. And that, by and large, is the goal of the well-intentioned ESG movement. But the traditional measurements we use to understand a business’s value added still very much matter, no matter how incomplete the snapshots are.
Perhaps the answer lies in balancing these two extremes, or at least knowing when one or the other is most appropriate. As we age, our responsibilities continue to evolve. So too, must the evolution of a firm. Success demands increased levels of responsibility. Today’s rising monopolies show varying degrees of social responsibility but are largely giving little attention to the subject. Their long-term values demand they rise to the occasion.
“The price of greatness is responsibility.” -- Winston Churchill
