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April 23, 2013
The Dismal Science
The Barbarians
by Adam Smith

Many years ago, I was watching a late night talk show and James Garner was talking about a movie he just made called Barbarians at the Gate. The movie is about the hostile takeover attempt of RJR Nabisco. Garner talked about the bad evil people that were trying to attempt hostile takeovers of companies (the barbarians). These takeovers where somewhat prevalent at that time and companies implemented what were called poison pills to try and keep corporate raiders from coming after their companies.

When I heard Garner talking, I was convinced that he was right. He is so likable and was always one of my favorite actors so of course he must be right. Well, I heard Garner prior to going back to school and learning a few things and learning to loathe those that loathe the barbarians.

Of course this will take a little explaining.

First, it is always easy to think a corporation as this big conglomerate of people. However, a corporation is really not any different than any small business in your community.

There are people that own the company, the shareholders. They are just like the couple that owns a local dry cleaning business. They have invested their money in a business they think will do well and will give them a return on their investment. If the company goes bankrupt they lose all the money they have invested.

There are people that manage the company, the CEO etc. They are just like the manager of the dry cleaning store. They are there to make sure the company runs efficiently, money is not lost or stolen, and that the store returns a profit for the owners.

There are creditors to the company, the banks that loan money to the company. They are just like the local bank that loaned the couple the money to get the dry cleaning business started. The creditors looked over the business plan of the couple and concluded this was a viable business and that the dry cleaning business would make enough money to pay them back with interest.

There are people that work at the company. They are just like the people in the back of the dry cleaning business that actually get things done.

The big difference between the couple owning the dry cleaning business and the shareholders of the corporation is proximity. The couple can easily observe what is happening in the business and make corrections when they think the manager is doing something wrong. The shareholders have very limited visibility into the activity of the business. That is why corporations have a Board of Directors, to represent the shareholders. The Board regularly meets, at least quarterly, with the corporation’s management to understand the business and make corrections when they think management is doing something wrong.

Not all Boards are created equal. Some are very active and try to do a good job monitoring management. Some less active, they may have several member of the company’s management on the Board, and do a poor job monitoring.

Not all managements are created equal. Some work very hard to try and make the company as successful has possible. Others only look at enriching themselves and load up on the perquisite consumption.

The biggest issue with management is when an incorrect decision is made and money is being invested in a losing cause. Does management admit the mistake and stop the money flow to the losing cause? Is the Board also willing to admit their mistake of allowing the bad investment?

Many times there is the unfortunate intersection of bad corporate management and poor or less active over-site by the Board. In this case, management of the company is taking a lot of money from the company for their personal consumption and/or pouring money into losing investments.

These are the exact companies that the barbarians are looking to buy.

The performance of these companies lags those of other like companies. The barbarians may not know exactly why there is a lag, but they know there are inefficiencies in the company that, when eliminated, will make the company much more profitable and cause the value of the company to increase.

For example, consider a company that is poorly run and their price for a share of stock is $10. Along comes a barbarian and says that he will buy stock of the company for $12/share. What will happen next?

First, the management of the company will say $12/share is way too low of a bid. That the company is worth way more than the $12/share being offered. The market just does not know the true value of the company. The market is too short sighted and they are investing long term. Blah, blah, blah. This is an obvious sign of a very poorly run company. The management has the opportunity to immediately give the owners of the company a 20% return on the value of a share. Thoughtful evaluation at a minimum is required.

The poison pills I mentioned earlier in the article usually take the form of huge payouts to current management in case of a hostile takeover. These poison pills, approved by the Board, are very effective at keeping away the barbarians. So who are the losers by keeping the barbarians away from the gates?

Really it is everyone but management and the Board.

The shareholders lose because the bad management is allowed to continue causing a suppressed stock price. It is like the couple that owns the dry cleaners watching a store manager fritter away money and not being able to fire him. The barbarians fire the company’s management and Board. In today’s society, nobody cares about the shareholders/owners of corporations even though with the prevalence of 401k’s most people in America have a vested interest in corporations being well run.

The creditors lose because a poorly run company will eventually end up in bankruptcy court and they will not get all of their money returned.

The employees lose. One of the reasons progressives hate takeovers is because when the barbarians start to rationalize the business, unprofitable segments of the business are discontinued. This means people lose their jobs. Remember the vilification of Romney for restructuring companies his equity firm purchased. So why do employees lose if barbarians are restrained? Once again, the bad companies end up in bankruptcy and the restructuring of the business generally involves a lot of reduction in employees. Course correction by the barbarians may mean some reduction in employees, but when profitability hopefully returns, then the company starts to hire again.

Only the poor management and derelict Boards win. They continue to collect their salaries, receive undeserved bonuses, get restricted stock units, receive stock options, fly on the corporate jet, and have lunch and dinner brought in every day. Excuse me while I take a minute to wretch.

That’s why I loathe those that loathe the barbarians. The loathers of the barbarians, despite what they say, actually hurt the company’s owners, creditors, and employees. They are standing up for the unethical part of the 1%.


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