Beating Your Plants to Death

...or How to Avoid Stranding Your Capital

As we said before, recent poor U.S. economic results have been strongly driven by stranded capital in the housing sector. What can this idea tell us about practical management of future investments, such as investing in M&M-making machines?

Clearly, the primary lesson is avoid investments in which you bear a high risk of stranding your capital. If the future is very uncertain, then the promised return had better be high or occur quickly. Other techniques for reducing the risk include all of the classic lessons of investment finance theory, such as diversification across assets and asset classes. These lessons are taught many places; pick up a finance or investment textbook to learn more there.

Going further, the truly significant returns on capital occur when we're investing in real assets, not paper like equity and debt securities. Even if we are investing in paper assets, our best returns will occur when we investigate the company as though we were considering managing or owning the whole thing ourselves. Hence, whether we are an actual manager or a passive one, we still have the task of evaluating the best way of making real investments.

By "real investments" I mean primarily purchase of capital goods. This also includes long-lived supplies, if we are required by circumstances to hold supplies over some long period of time, or if some risk outcomes would involve our holding supplies unintentionally for a long period.

On the surface, it seems like an easy job: Buy only equipment you need. Don't pay too much. Think about it first so that you don't buy the wrong thing.

In full, however, this task is one of the more difficult tasks in business. It can be used to show why certain investors are better than others, why certain national growth rates arise because of different political systems, why some industrial sectors are more productive than others, and of course why some managers are better than others. It might also be useful in analyzing sources of inequality of economic outcome in a population.

Making a real investment requires estimating the future course of events. The better you are predicting the utility of your capital good, the more likely you will get the expected return.

The quality of your investment will also depend on the number of choices you have. Awareness of more options and the availability of multiple options will increase the likelihood of finding an excellent investment. If you have only a few choices, the probability of finding an excellent return is diminished.

What may be more surprising to most of us is that operational execution has a large influence on the investment return as well. Money well spent can be lost through poor use of the capital good. Excellent employment of a marginal piece of equipment can generate impressive rates of return. Most importantly, the actual use of the capital good must drive the original decision to buy it.

The best illustration that comes to mind is an article on M&M/Mars written 17 years ago and which appeared in Fortune magazine. The passage:

"The reason most often cited for Mars's distribution problem is its long-held policy of maximum asset utilization or, as some put it, beating its plants to death. The company is obsessed with asset utilization..."

The phrase "beating its plants to death" speaks volumes. One can imagine senior management carefully watching to make sure that every production line, every machine, every bit of signage, and the capitalized labor effort required to establish production is amortized over as many billions of M&Ms and candy bars as possible. If a machine can be used to make a billion M&Ms, then can we run it out even more and get it to make two billion? And then three, and ten billion? When someone suggests that we reconfigure a line, has it been too soon since the last rearrangement (capital injection) and did we get our money's worth from that last arrangement?

Measurements of asset utilization in this case are so far ahead of "winging it" that it's not funny. Any competitor making a decision about equipment that doesn't consider capital return rates will be at a severe disadvantage. The candy-making business is marked by fairly consistent predictions of future demand and steady supplies, so the future is much more predictable. When the future is predictable, quantification of the investment analysis is an excellent choice.

There is power and beauty in that phrase "beating its plants to death." This is the path to follow to avoid stranding your capital: Can you use the candidate item so much and so often and so profitably that you will have figuratively beaten your capital good to death by the end of its useful life? This is what you seek. You want the result to be equipment that is so well-used, so worn at the end, cycled so many times that it is like a member of the family. Every investment needs to be compared to this standard. Those that pass are much less likely to become stranded. Those that don't, you may not want.