Dead Fish

by Christopher Mayer

Vancouver played host to the Agora Wealth Symposium this year, where I was a speaker and an attendee. I found the city to be very clean and the people exceedingly polite, at least by American standards.

I stayed at the Fairmont Hotel in downtown Vancouver, where my room provided a terrific view of the harbor down Burrard Street and overlooked a marvelous 115-year-old cathedral on Georgia Street.

Like most cities, Vancouver’s history brings together disparate elements. It is the home of BOTOX inventor Dr. Jean Carruthers, as well as the city where Greenpeace was founded, in 1971. I did find some of its history interesting, especially since, while I was there, the history of the place seemed to reach back out of the past and spread itself on the nation’s newspapers. The market has no special regard for history, as the travails of the Hudson’s Bay Co. attest.

Hudson’s Bay Co. is a 334-year-old department store chain. It is Canada’s oldest company. While this advanced age certainly deserves respect and inspires wonder, it seems to buy you no quarter in the rough-and-tumble world of making money.

Hudson’s Bay Co. is struggling these days, and the papers report that the tired old merchant has had enough and may be sold. Target and investor Jerry Zucker are competing suitors to buy the company.

This fact, of course, has fanned the burning embers of patriotism in Canada, as they lament the passing of such a venerable institution. Hudson’s Bay is the last domestic department store since 133-year-old Eatons failed in 1999.

Not all Canadians were so sentimental, however. Eric Reguly of The Globe and Mail was surprised the old dame attracted any suitors at all. Reguly writes, “It seems unlikely that a perennial stock market loser, a company with a lousy return on equity and capital, one that seems in a permanent, and increasingly desperate state of reinvention, could attract takeover bids.”

Vancouver’s history is also intertwined with that of Hudson’s Bay. It was Hudson’s Bay explorers who, in the summer of 1827, built a fur-trading post on the banks of the Fraser River, calling it Fort Langley. With the arrival of British Col. Richard Moody in 1858, he moved it further downstream and then, coveting an ocean view, moved it again to Burrard Inlet.

It was a wise choice, apparently, as trade and settlement flourished in the area. By 1887, the Canadian Pacific Railway was bringing people to the newly minted city of Vancouver.

Today, it seems to be a prosperous city, with sleek, modern buildings standing beside older, noble ones, with busy streets and shops and people hustling about town. The Hudson’s Bay Co. store I saw seemed busy enough.

Markets change, though, and while Hudson’s has been a loser, such things don’t usually persist forever. Just as periods of high returns invite competition and put pressure on future returns, so, too, do poor returns tend to rebound as market forces correct the error. Target may be able to do better with Hudson’s assets.

This theme of the cyclical nature of returns was the topic of one of my speeches at the symposium.

Only Dead Fish Swim With the Stream

Most people want to buy strong companies with growing sales and expanding markets and a bright future. No one wants to buy a company that has problems to work through, that has been hit with one setback or another and where the near-term outlook is murky and uninviting.

Yet it is in these latter opportunities where the greatest investors have plied their trade and milled their fortunes. Warren Buffett bought The Washington Post in the throes of the 1973 – 74 bear market, when it was struggling. He bought 10% of the company for about $10 million. At the time, the company had revenues of over $200 million. Ten years later, his stake was worth a quarter of a billion dollars.

He bought GEICO when, in his words, “It wasn’t essentially bankrupt, but it was heading there.” It was one his greatest acquisitions.

Not just Buffett, but scores of wealthy investors have enjoyed incredible returns by buying when other investors were fearful, by seeing through the temporary setbacks.

The greatest investors did not fear to go against the consensus. As writer Malcolm Muggeridge used to say, “Only dead fish swim with the stream.”

I’ve recently completed a book, which brought to mind many of these thoughts on the paradoxical nature of market returns. The book is titled Capital Account: A Money Manager’s Reports on a Turbulent Decade 1993 – 2002, and it is edited with an introduction by Edward Chancellor (author of the acclaimed Devil Take the Hindmost). The book collects financial reports written by Marathon Asset Management’s partners and delivered to its clients over the boom years. Marathon is an investment advisory firm based in London that manages over $24 billion in assets for institutional investors.

The book was interesting because it illustrates Marathon’s unconventional investment style and provides a number of useful ideas and examples of investments that succeeded by bucking consensus opinion.

Consider General Dynamics, a company that Marathon backed in the early 1990s. General Dynamics was in bad shape at the time, suffering from a declining backlog of business in the wake of the Soviet Union’s demise.

New management took the company in a different direction in 1991 – by closing or selling unprofitable businesses and buying back its own depressed shares.

The stock of General Dynamics increased six fold between 1990 and 1993, even though its sales were reduced by half.

Yes, sales declined by 50% and the stock rose six fold!

Marathon used the example to highlight a couple of key points regarding their “capital cycle approach” (which we’ll get to in a minute). First, investment returns can have less to do with sales and growing markets than they have to do with the efficient allocation of resources.

In this case, the management of General Dynamics took the existing resources of the company and dramatically changed the way those resources were deployed. Instead of frittering them away on unprofitable business lines, management focused on its core business. Even though this involved effectively making the business smaller, investors were rewarded with an outsized gain in the stock price during a relatively short amount of time.

Secondly, Marathon pointed out that General Dynamics benefited from a decline in competition, as money was withdrawn from the defense sector or diverted to other areas and the existing businesses consolidated. As Chancellor writes, “It is better to invest in a mature industry where competition is declining than in a growing industry where competition is expanding.”

Marathon has named its approach the “capital cycle approach.” The approach is based on a simple yet compelling idea. High returns on capital, or the prospect of high returns on capital in one area of the market, will attract additional investment. This additional investment will put downward pressure on returns in that market.

Think about the Internet bubble. When the Internet was still new, the first few firms in the space commanded large market caps relative to the amount of capital invested in the business or the amount of money required to start the business. As a result, more money kept pouring into dot-com businesses.

Let me give you Chancellor’s distillation of this idea, and you will never forget it.

He wrote, “When a hole in the ground costs $1 to dig but is priced in the stock market at $10, the temptation to reach for a shovel becomes irresistible.”

Using the capital cycle approach, you would become suspicious when shares are priced on the assumption that existing returns are going to be maintained or improved in light of rapidly expanding new investment and growing capacity in a business or industry. In other words, the approach helps guard against the error of simply extrapolating prior returns into future years. Capital cycle forces you to think about competitive pressures.

The process works in reverse as well. As share prices decline, investment capital moves off to find greener pastures and competition declines. As excess capacity is sweated off, though, returns are likely to improve. Here is where there is opportunity, as share prices in these situations are often priced assuming the pessimistic present conditions are permanent. But as things improve, as the market naturally adjusts, these companies may provide outsized returns for far-seeing investors. General Dynamics did exactly that. Target may be able to do that with Hudson’s Bay.

Christopher Mayer

Christopher Mayer is the editor of the Fleet Steet Letter.

His contrarian essays have appeared on a number of Web sites and publications, including, The Mises Institute, the Freeman, The Daily Reckoning,,,,, Grant’s Investor and Individual Investor Magazine. His views on financial matters have also been widely quoted, including in the highly regarded Grant’s Interest Rate Observer.

Chris began his career in banking, specifically, corporate lending, after earning an MBA with a concentration in finance, He later started writing Capital & Crisis, a monthly newsletter that gave Chris’ unique brand of financial commentary a more regular and expanded format.

With an unusual fondness for old books, old investors and old ideas, Chris fits perfectly into the Fleet Street mold. He claims a personal library of over 400 books, numerous periodicals, papers and pamphlets, which he brings to bear on understanding the financial world of today.