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THE CATERPILLAR WAY
LESSONS IN LEADERSHIP, GROWTH, AND SHAREHOLDER VALUE
By CRAIG T. BOUCHARD, JAMES V. KOCH
McGraw-Hill EducationCopyright © 2014 Craig T. Bouchard and James V. Koch
All rights reserved.
THE QUEST FOR THE HOLY GRAIL
This book is about greatness and specifically about Caterpillar Inc., a superb example of a once struggling company made great by a deliberate sequence of astute management decisions. Caterpillar today is the world's leading manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives. Financial analysts say that its global market share is increasing and that it is churning out profits.
But things weren't always this way. In 1984, Caterpillar lost $1.17 million every day as it suffered through its third down year in a row. There were whispers that bankruptcy could be somewhere down the street if CAT (this is how most people close to the company affectionately refer to it) could not turn things around.
However, turn things around is precisely what Caterpillar did even as many similarly situated firms fell into the ditch. In 2012, Caterpillar was ranked number 46 on the Fortune 500 list of the largest American corporations, up from number 58 the previous year. Its composite revenues and sales were $65.88 billion in 2012, a tenfold increase since 1984. In November 2012, Caterpillar's annual sales were 1.9 times as large as those of its nearest American competitor, Deere, and 2.7 times the size of those of its largest international competitor, Komatsu.
Between January 2, 2001, and January 2, 2013, CAT's stock price rose an amazing 443 percent while the S&P 500 increased only 12.3 percent. Further, the company's dividend per share increased 269 percent between 2001 and 2012 and now has increased 20 years in a row.
By any standard, these achievements represent conspicuous success and help define what it means to be great. Nevertheless, the topic of good versus great is once again in vogue because on closer inspection, so few things seem genuinely great. Not in the United States, not in Europe, and not in the BRICs (Brazil, Russia, India, and China) either. Consider the implications of this assessment. It's increasingly difficult to find the qualities usually associated with greatness either in countries or in companies. The BRICs, for example, used to be synonymous with dynamic economic growth, but now that their growth has decelerated, they appear more vulnerable, and it is possible that they may lead the world into recession. It seems apparent that the global economic environment has changed, perhaps not forever but certainly for the foreseeable future.
As authors and as businessmen, we have glimpsed greatness a few times during our careers. Truth be told, getting a small whiff of it in our prior experience building Esmark, Inc., and Shale-Inland (both billion-dollar steel-related enterprises) made us eager to explain why some organizations are able to scale to higher levels of productivity and performance while others flame out and fall short. We sense that we're not the only ones who want to know why. This is a topic of great interest not only to directors, CEOs, and managers of companies but also to investors large and small.
Unfortunately, never in our lifetimes have so many managers and investors been so confused and uncertain about what constitutes the path to great business performance.
In today's equity and bond markets, this insecurity translates into massive doubts about how and where one should invest. It is not a mystery why this is so. Unmistakable uncertainties exist with respect to Europe's ability to work through its financial crises, the Middle East is a tinderbox, the Chinese economy has slowed, and Japan appears to be in the middle of yet another lost decade.
In the United States, no one really knows how the new health-care legislation will work or what it will cost. Nor do we know what our tax rates will be next year, much less five years from today. How will we pay for anticipated spending on entitlements? Our burgeoning national debt waits to be paid by future generations. The list of uncertainties is long.
Hanging like a cloud above all our heads is the reality that 14.3 percent of Americans were unemployed or underemployed in June 2013. Regrettably, this means that many millions of individuals are being forced to start over in their careers, sometimes at a terrify-ingly late stage of their lives.
Some have responded bravely to these circumstances by taking the plunge and starting a new company. Not only do these entrepreneurs need to make the right choice with respect to what kind of business they should start, but also they need an understanding of what generates organizational greatness so that they can rely on these principles from the very start. In light of the fact that only 8 percent of new businesses reach 29 employees within 10 years, individuals investing their precious cash reserves want to know how new firms can grow to become great firms as well as how to plan for the troughs in economic activity that inevitably will occur.
Even the more fortunate among us face uncertainties because the world is in constant flux. Who is willing to stake his or her 401(k) balance on what the relationship between Israel and Iran will be five years from now? Who is capable of telling us what the capital gains tax rate will be five years from today or whether the promising "reshoring" of manufacturing into the United States will continue? Hence, even those who are invested intelligently today could experience unanticipated financial distress tomorrow. We all have a need to know how to identify management excellence within firms so that we can utilize that knowledge in the stock market.
Thinking About Today's Investment Environment
James Tobin and Harry Markowitz are academic titans. Each won a Nobel Prize in economics for advancing our knowledge of the best ways to invest funds and develop optimal financial portfolios. However, in the decades since Tobin and Markowitz won their Nobel Prizes, investing has become more complicated, ways to invest have grown appreciably since the 1980s, and these new opportunities usually are more complex. Consider financial derivatives. Although some kinds of derivatives have been around since the 1700s, until recent decades, they were not much more than a gleam in a financial innovator's eye. Today, a bewildering variety of derivatives exists, the most simple of which are forwards, futures, and options. Less than 1 percent of investors in the stock market ever dabble in derivatives because it is too difficult for most of them to estimate and price the risks involved.
Structured investments such as those containing subprime mortgages did not exist when Tobin and Markowitz were doing their pioneering work. Investment opportunities in commodities and real estate certainly did exist, but the alternatives were plain vanilla compared with the intricate opportunities that exist today. Exchange-traded mutual funds had yet to appear on the scene. Thus, the number of available investment opportunities has multiplied in number and increased in complexity, and this has made investing more complicated.
One of the biggest changes in the habits of investors is that many now choose to index their investments to reflect the entire stock market. Sometimes they don't know they are doing this because their pension fund invests their contributions and they don't pay much attention. In other cases, they personally choose to invest in indexed mutual funds sold by firms such as Fidelity and Vanguard, funds that attempt to imitate the entire stock market. For most investors, indexing turns out to be the optimal strategy. After all, accumulated evidence suggests that the typical individual investor or hedge fund that targets individual stocks does not do as well as the market overall and frequently does worse.
This means that many individual retail investors no longer spend much time consciously evaluating the characteristics of specific firms. Most investors have given up investing in people; that is, they no longer take into account the values and behavior of those who lead companies. We believe this is a mistake. We believe it makes a huge difference not only what one invests in but also who leads the companies in which one invests. "Who is going to lead the parade?" remains a salient investment question because leadership makes a significant difference in company performance.
Who is leading the firm? What are their values? How do they go about conducting their business? Private equity funds continually ask these questions, though their collective performance suggests that they often don't end up with the right answers. Institutional money managers ask the same questions. Alas, most retail investors don't know how to ask these questions or discover the answers.
In an odd way, the investment models of Tobin and Markowitz are responsible for the modern de-emphasis on the human component when one invests in stocks. Their classic models focused on two critical variables: the mean return one could earn on an asset and the standard deviation of that return. The duo didn't worry about the identity or values of the leaders of the companies whose financial assets they were analyzing. Tobin and Markowitz passed over any complications in this regard by making the usual ceteris paribus assumption that underpins so much of economic theory. That is, they held constant quite a few variables, such as managerial abilities and values, and implicitly assumed that those factors were not crucial considerations.
The work of Markowitz and Tobin was pathbreaking and deserving of a Nobel Prize because their theory underpins modern portfolio analysis and the well-known capital asset pricing model. Wall Street fell in love with their formulations and adopted their way of looking at things. Of course, it is essential to know which firms have generated the highest average returns in the past and how variable those returns have been. But portfolio analysis is not helpful in figuring out when a star performer on the New York Stock Exchange (NYSE) or Nasdaq will hit the wall and bog down with management issues associated with fast growth and scale.
We've cited Caterpillar's magnificent performance and could assemble a portfolio of firms to invest in by relying on similar track records of growth and stock appreciation. However, as television ads constantly warn us, past performance is no guarantee of future returns. Next year will bring different circumstances. What will the firm's managers do when faced with adversity? How will they react when, like Caterpillar, they are faced with strong new international competition and their exports are burdened by a strong U.S. dollar? What path will they choose when, like Caterpillar, they face a well-funded entrenched labor union, such as the United Auto Workers, that is insistent on imposing an industry pattern bargain solution on their firm that they believe is not in the best interest of the shareholders? What course of action will they take when, like Caterpillar, they conclude that their current organizational structure is obsolete and ought to be changed?
Great firms have managers who answer these questions as well as the questions we do not yet know. This underlines a basic reality: if you are not going to index your investments, you must pay attention to the quality of managers, the nature of the managerial processes they follow, and the way they arrive at decisions.
The Changing Investment Environment
Take a peek at your 401(k) or pension account. How has it been doing? The answer for many people is a bit embarrassing: their account balances are smaller today than they were 10 years ago. This should come as no surprise. As already noted, between January 2, 2001, and January 2, 2013, the S&P 500 stock index actually rose only 12.3 percent. During that period, the consumer price index (CPI) rose 30.0 percent. In real terms, the S&P 500 index declined by about 18 percent. No wonder many investors feel they have been bashed by the market.
These computations don't include dividends paid by S&P 500 firms, but if we generously approximate those dividends at 1.5 percent per year, the total value of an investment that imitated the S&P 500 rose by about 30 percent, or about 2.5 percent per year. However, if we once again deflate this gain by the CPI, the real value of an investment that imitated the S&P 500 over this period virtually stood still. Buying and holding the S&P 500 was a disappointing proposition in the period 2000–2012.
The moral of the story? Today it is folly for most investors to assume or expect high rates of return on equity or debt portfolios. After all, in early July 2013, a one-year U.S. government note yielded only 0.124 percent and a 30-year U.S. government bond yielded only 3.683 percent. Federal Reserve Chairman Ben Bernanke informed all who cared to listen that these rates could persist for some time into the future. If he's right, rates of return earned on bonds are likely to be minimal. If he's wrong and interest rates rise, the prices of bonds will decline substantially. This rise in rates will hurt bondholders because lower bond prices will puncture what easily could be interpreted as a bond price bubble encouraged by Federal Reserve policies.
There have been changes in the nature of the risks attached to investments as well. In the past, individual investors could reasonably assume that their investments in the stocks of large banks and public utilities and the money they put into corporate bonds were safe, secure, and substantially immune to bankruptcies or default. This view of the world, however, was badly damaged by the 2008 demise of Washington Mutual ($307 billion in assets), the meltdown of the Fortune 500 public utility Montana Power, the sudden disappearance of Wall Street's Lehman Brothers, and the bursting of the real estate price bubble. Investors now realize that the size and fame of a firm provide no guarantee of intelligent management of that firm. Lehman Brothers, for example, had accumulated assets of approximately $600 billion and enjoyed a sterling reputation. But it became overleveraged during the 2008 financial crisis and had to declare bankruptcy—still the largest one in history.
Meanwhile, investments in residential real estate turned out to be notoriously bad between 2008 and 2011. The average equity that homeowners held in their houses fell from almost 60 percent of market value in 2000 to only 43.1 percent in the second quarter of 2012. Our homes may be our castles, but they haven't been wonderful investments. Declining real estate values are an important reason the Pew Foundation reported in August 2012 that median household net worth had fallen from $152,950 in 2008 to only $93,150 in 2010.
Contrast these dismal results with the performance of Caterpillar. As already noted, between January 2, 2001, and January 2, 2013, the price of CAT stock rose 443 percent. Add to this a dividend payment that averaged about 2.3 percent annually. Such dividend payments are likely to continue; the company's public commitment is that it will pay dividends that will rank CAT in the top 25 percent of all S&P 500 dividend payers.
This leads us to the central question: How can we identify the qualities and characteristics of firms that become better as they grow larger and reach higher levels of scale? As we will discuss later in the book, it's not a foregone conclusion that bigger is better when it comes to return on shareholder equity. One need look no further than the performance of famous brands such as Microsoft, Walmart, Bank of America, and General Electric (GE) to illustrate this point. A shareholder buying and holding these stocks for the last decade did not do well.
Excerpted from THE CATERPILLAR WAY by CRAIG T. BOUCHARD, JAMES V. KOCH. Copyright © 2014 Craig T. Bouchard and James V. Koch. Excerpted by permission of McGraw-Hill Education.
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