Beating the Street (29 page)

I probably don't need to tell you that can making is a lousy industry with a thin profit margin, or that Crown Cork & Seal is a low-cost producer. Its ratio of expenses to sales is 2.5 percent, which is more than a couple of notches below the industry average of 15 percent.

This piddling level of expenditure, bordering on the monastic, was inspired by John Connelly, the CEO, who recently died. Connelly's hostility to extravagance brings us to Peter's Principle #17:

All else being equal, invest in the company with the fewest color photographs in the annual report.

Connelly's annual report had zero photographs. Where he didn't mind spending money was on the new can-making technologies that enabled CC&S to maintain its status as the lowest-cost producer.

Profits that weren't reinvested in improving the can-making operation were used to buy back shares. This boosted the earnings for the remaining shares, which boosted the share price for the lucky shareholders who hadn't sold. You'd almost have thought that Mr. Connelly was working for the shareholders, which at many companies is an eccentric thing to do.

Since Mr. Connelly's death, the company has changed tactics. It now uses its sizable cash flow to buy out its rivals and grow via that familiar method. Capital spending has increased and so has the debt level, but to date the new tactic has been as profitable as the old one. The price of Crown Cork & Seal moved up from $54 to $92 in 1991.

Nobody wants to be in the steel business these days, with all the competition from the Japanese and the billions invested in equipment that may soon be outmoded. The big-name producers, U.S. Steel (alias USX) and Bethlehem Steel, once symbols of American prowess, have tested their shareholders' patience for 12 years. Bethlehem fell to $5 a share in 1986 and has come a long way back from there, but at the current price of $13 it still has a long way to go to return to its high of $32 in 1981. USX has also yet to return to its 1981 high.

Meanwhile, if you'd invested in Nucor in 1981, your $6 stock would
be worth $75 today, and you'd think the steel business is a great business after all. Or if you'd gotten into Nucor for $1 a share in 1971, you'd now be convinced that steel is one of the greatest businesses of all time. You wouldn't think so if you'd bought Bethlehem for $24 a share in 1971, because now you'd have $13, the sort of result that gives investing in Treasury bills a good name.

Here again we have a penurious maverick with a vision, F. Kenneth Iverson, who's not above taking fancy corporate clients to lunch at Phil's Deli across from corporate headquarters in Charlotte, North Carolina. There is no executive dining room at Nucor, there are no limos in the parking lot, there is no corporate jet at the airport, and there are no special privileges for wearing a suit—when profits decline, the people in the suits and the people in the overalls both take home less pay. When profits increase (as they usually do), everybody gets a bonus.

Nucor's 5,500 employees don't belong to a union, but they fare better than their colleagues at other steel plants who do. They share in the profits and they can't be laid off. Their children get college scholarships. If the economy slows down and production is cut, the entire work force puts in a shorter week, so the suffering of the layoff is shared.

Nucor has had two niches in its history. In the 1970s it specialized in turning scrap metal into construction-grade steel. Lately, as other companies have caught on to this process, Nucor has kept a step ahead of them by learning to produce a high-grade, flat-rolled steel. These flat-rolled sheets can be used for auto bodies and appliances. With this new “thin-slab casting” technique, Nucor can now compete directly with the Bethlehems and the USXs.

A search of a magazine data base for articles about this company produced two listings. There was a paragraph in
Textile World
and a sentence in an obscure technology journal called
Datamation.
I also found two feature articles in
The Wall Street Journal
and one from the PR Newswire. Apparently, very little has been written about this $1 billion enterprise, soon to be a $2 billion enterprise, that has captured 20 percent of the carpet business in the U.S.

In keeping with our Great Opportunities in Out-of-the-Way Places
theme, Shaw's headquarters are in Dalton, Georgia, located on a southern hump of the Blue Ridge Mountains and at least two hours from a major airport. Historically, Dalton is famous for moonshine, clog dancing, and the fact that in 1895 a young girl from the area figured out a way to make tufted bedspreads. This new tufted bedspread technology led to a boom in bedspreads, which led to a boom in carpets—but Shaw wasn't around back then.

Shaw didn't get started until 1961. The founder, Robert Shaw, now 58, is still the president and CEO and his brother, J.C., is still the chairman. In the sketchy news accounts, Robert Shaw is described as a person of few words, most of them serious. Behind the president's desk hangs a banner with this catchy motto: “Maintain sufficient market share to allow full utilization of our production facilities.”

One time he made people laugh was when he announced that Shaw Industries would become a billion-dollar company. The guffaws could be heard all the way to the offices of West Point-Pepperell, a giant in the industry that sold twice as many carpets as Shaw. They stopped the day Shaw bought out West Point-Pepperell's carpet operations.

There hasn't been a worse business in contemporary America. In the 1960s, when the Shaw brothers got into it, so did everybody else who had $10,000 to invest in a carpet factory. The area around Dalton was stippled with small mills, as 350 new carpet makers revved up their looms to meet the nation's demand for a carpet on every floor. Demand was great, but supply was greater, and soon enough the carpet makers responded by cutting prices. This ensured that neither they nor their rivals would make money.

Then in 1982, homeowners rediscovered the wood floor and the carpet boom came to an end. Half the top 25 manufacturers were out of business by mid-decade. Carpet has been a nongrowth industry ever since, and Shaw has thrived as the low-cost producer. With every competitor that fails, it picks up more business.

Shaw pumps every available dollar into improving operations and cutting costs even further. Tired of paying a high price for yarn, it acquired a yarn-making facility and eliminated the middleman. It has its own distribution network with its own fleet of trucks. In its never-ending quest for economy, Shaw opted not to maintain an expensive trade showroom in Atlanta. It sends a bus to Atlanta and transports its customers to Dalton.

During the worst of times for carpets, Shaw has managed to keep up its 20 percent annual growth rate. The stock price has followed along dutifully, up 50-fold since 1980. It lagged a bit in 1990–91 and doubled again in 1992. Who would have believed we'd see a 50-bagger in carpets?

In May 1992, Shaw purchased Salem Carpet Mills, further strengthening its grip on the industry. Shaw now predicts that by the end of this century three or four huge companies will dominate carpet making worldwide. Competitors worry that a single huge company will dominate carpet making, and they already know which one.

Savings and loans are the latest untouchables among equities. Mention the term and people grab for their wallets. They think about the $500 billion S&L bailout bill we all have to pay, the 675 bankrupt institutions closed since 1989, the lavish spending by their officers and directors, the 10,000 bank fraud cases pending with the FBI. The word “thrift” once reminded us of Jimmy Stewart in
It's a Wonderful Life.
Now it's Charles Keating in handcuffs.

Since 1988, it's been impossible to pick up a newspaper and not read some story about an S&L bankruptcy or a civil lawsuit or a prosecution or Congress's struggle with the bailout bill. At least five books have been written on the sorry subject, and not one has been called
How to Make a Fortune on S&L Stocks.

Yet for the scores of S&Ls that have stayed out of trouble or survived it, it still is a wonderful life. Based on equity-to-assets ratio, the most fundamental measure of financial strength, more than 100 S&Ls are stronger today than the nation's strongest bank, J. P. Morgan. People's Savings Financial of New Britain, Connecticut, to name just one, has an equity-to-assets ratio of 12.5, while J. P. Morgan's is 5.17.

Other factors combine to make J. P. Morgan the preeminent bank that it is, so the comparison with People's Savings Financial is somewhat fanciful. The essential point is that many S&Ls are in terrific financial shape, which is the opposite of what we've been hearing.

There are also plenty of S&Ls in lousy financial shape, which is why it's important to make distinctions. I've identified three basic
types: the bad guys that perpetrated the fraud, the greedy guys that ruined a good thing, and the Jimmy Stewarts. Let's take these one at a time:

The tried-and-true scheme, which was quickly duplicated by connivers across the nation, worked as follows. A bunch of people got together, let's say 10 for simplicity's sake, and put up, let's say, $100,000 apiece to buy the In God We Trust S&L on Main Street. With their $1 million in equity, they could take in $19 million in deposits and make approximately $20 million worth of new loans.

To acquire the $19 million, they offered an exceptionally high rate of interest to attract certificates of deposit, and hired brokers such as Merrill Lynch and Shearson to raise the cash. A few years back, you probably saw the ads in the papers: “In God We Trust offers a 13 percent jumbo CD, guaranteed by the FSLIC.” With the government standing behind it, In God We Trust had no trouble selling CDs as fast as it could print them. The brokers were delighted with the rich commissions.

Soon enough, the owners and directors of In God We Trust were lending the $20 million proceeds from the CDs to friends, relatives, and associates for a variety of construction projects of dubious merit. This created a building boom in a lot of places that didn't need buildings. Meanwhile, the S&L looked very profitable on paper because of the enormous up-front fees it skimmed off the top of these loans.

These “profits” were added to the S&L's equity, and for every dollar the equity was increased, the owners and directors could make another $20 worth of loans. The system fed on itself, which is how small-town S&Ls such as Vernon in Texas got to be billion-dollar operations. As the loans grew, the equity grew, until soon there was enough money to pay kickbacks to accountants and auditors and tributes to representatives and senators on the powerful banking committees, with enough left over for Lear Jets and parties with hookers and imported elephants.

With some notable exceptions, such as Charles Keating's, the vast majority of the fraudulent S&Ls were privately owned. The owners
and directors involved in the dirty tricks couldn't have tolerated the scrutiny of a publicly held company.

You didn't have to be a crook or a con man to sink an S&L. All you had to be was greedy. The trouble begins when the directors of First Backwater Savings look around and see their competitors at In God We Trust and elsewhere getting rich on fees from the big commercial loans they've advanced to their cronies. As other institutions make millions overnight and brag about it at cocktail parties, First Backwater plods along, making old-fashioned residential mortgage loans.

These First Backwater directors hire a Wall Street expert, Mr. Suspenders, to advise them on how to maximize profits. Mr. Suspenders always has the same idea: borrow as much money as the rules allow, directly from the Federal Home Loan Bank, and put it into a few of those wonderful commercial deals that the other S&Ls are making.

So First Backwater borrows money from the Federal Home Loan Bank, and also sells CDs, and its ads appear in the papers alongside the ones from In God We Trust. It takes the cash and gives it to developers who want to build office parks, condos, and shopping centers. First Backwater may even become a partner in some of these projects, to make more profits. Then the recession hits and the would-be tenants for the office parks and condos and shopping centers disappear, and the developers default on the loans. The net worth of First Backwater, which had been built up for 50 years, evaporates in less than 5.

Essentially, this is the In God We Trust story all over again, except the directors at First Backwater didn't lend the money to their friends, and didn't take kickbacks under the table.

The Jimmy Stewart S&Ls are my favorites. They've quietly been making a profit all along. These are the no-frills, low-cost operators who take in deposits from the neighborhood and are content to
make old-fashioned residential mortgage loans. They can be found in small cities and towns across America and in certain urban areas the commercial banks have overlooked. Many have big branches with enormous deposit bases, which are much more profitable than having a lot of tiny branches.