Sunday, December 04, 2005

Creative Destruction is Healthy

A lot of my friends keep looking for an opportunity to buy General Motors or Ford because they are "down." Old friends of mine from Windsor and Detroit wonder if there is any future in the automotive industry.

Fortunately, as Buffett instructs us, we need not swing at every pitch. Fat pitches where we have a sense of value and a sense of competitive advantage are the only ones that are worthy of our attention.

The problems of both F and GM are well known and in the opinion of many, well-discounted in the stock price. Yet, when we begin to apply a discounted cash flow valuation methodology to the cash flows, we inherently are looking for an initial period of "excess" returns, that is, returns which are above the cost of capital. In the calculation of the terminal value, the excess returns collapse to a normal cost of other words, excess returns are zero.

As well, the calculation of the pension liability and the post-retirement health care liability is very dificult to nail down. In fact, reasonable estimates of these liabilities are at odds with the accounting definition and likely would eliminate for both companies, almost all of their shareholder equity. In my view, bond covenants would be severely challenged.

There is an economic justice in all of this. Creative destruction as Schumpeter espoused, drives out the old economic structure, but remember, it also creates a new one. Higher quality and more attractive Japanese and Korean imports, better assembly methods with lower labor input costs, and crisper, more adept managements that can accelerate the trip from concept to production are all Schumpeter forces of creative destruction that provide investable opportunities elsewhere.

The essence of my analysis on this matter is "why bother." There is no fat pitch here despite the beguiling prices.

An excellent article about creative destruction was published last weekend in "The Sunday Times." I think it is a worthwhile read!


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